Inflation, Unemployment, the Exchange Rate and Monetary Policy in Israel 1990-1999: A SVAR Approach

In this paper we estimate a four-equation quarterly structural VAR model of the Israeli economy during the years 1990-1999. The estimated system of equations includes an unemployment equation, an inflation equation, a nominal interest equation describing the evolution of the interest rate on monetary instruments controlled by the central bank and a nominal exchange rate equation. We used in our estimation two identification restriction sets, which allowed us to differentiate between two structural models. In the first model, model 1, the supply does not respond on impact to changes in aggregate demand while in the second model, model 2, the supply response is such that it maximizes the impact effect of demand shocks on unemployment. According to our estimation results positive shocks to the BoI interest rate slow down inflation and are reflected, in both structural models, in arise in the ex post real interest rate and in unemployment. The inflation response to interest rate shocks is rather fast as a result of the exchange rate response to the changes in the interest rate. There are no drastic differences between the estimation results of the nominal interest rate equation in the two models. In spite of the response of unemployment and inflation to monetary policy shocks, the variance decomposition results suggest that the central interest rate variability may be considered as being the source of a rather small fraction of inflation variability and of an almost negligible fraction of unemployment variability in both structural models. The analysis of the retrieved actual stuctural shows that deviation of the unemployment rate from its long run equilibrium level, during the period surveyed, should be attributed, in the context of model 1, to supply shocks. This is not however the case in model 2. In this model demand and interest rate shocks did also play a determining role, in addition to supply shocks, in bringing about the fall in unemployment between 1993 and 1995 and its rise between 1996 and 1999. Indeed the expansion of monetary aggregates between 1992 and 1994 was very fast, implying an expansionary monetary policy, while between 1997 and 1998 international trade growth fell following the crises in emerging markets inflicting an aggregate demand shock on the Israeli economy. The fact that model 2 gave rise to an expost monetary policy characterization similar to that supported by out of the model empirical evidence and that it identified demand shocks which are known to have occurred, suggests that it may be more suitable than model 1 in describing the Israeli economy during the period surveyed.