A Model For Monetary Policy Under Inflation Targeting: The Case Of Israel

In 1992 the Bank of Israel started to implement an inflation targeting regime. In this paper we formulate and estimate a small model to explain the determination of inflation, currency devaluation and the nominal interest rate under an interest rate rule designed to achieve the inflation target. We use quarterly data from the third quarter of 1992 to the third quarter of 2000. Monetary policy is represented by an interest rate rule according to which the nominal interest rate is adjusted according to the gap between inflation expectations and the inflation target, and the gap between the present nominal interest rate and its rate in the long run. In this formulation we use data on inflation expectations derived from the bond market. Inflation in the model is determined by currency devaluation plus the increase in import prices (abroad), inflation expectations and the gap between the short term and the long-term real interest rates. The last item represents the influence of monetary policy on the output gap. Currency devaluation is determined by the gap between domestic inflation and inflation abroad, and by the change in the differential between the domestic interest rate and that abroad. The model can be used for forecasting and for policy analysis, i.e., to evaluate the effect of shocks—for example unexpected devaluation—on the course of the endogenous variables. In such implementation we need to assume how expectations are made. We use two alternatives: rational expectations and adaptive expectations.