Estimation of a Macroeconomic Model for the Israeli Economy

This paper presents a formulation and an estimation of a small macroeconomic model for a small and open economy, as well as for the effect of the global economy on it. This DSGE type model allows for the overall assessment and analysis of the state of the economy throughout the business cycle, as well as of its long-term trends. The model is estimated by using a combination of Bayesian estimation together with calibration. The results of the estimation reveal that the last decade in the Israeli economy has been characterized by positive supply shocks, which are reflected in the combination of elevated activity, side by side with below-target inflation and an expansionary monetary policy. The appreciation in the real exchange rate, which has characterized the last 15 years, stems mainly, according to the model, from long-term structural processes. The development of the implied inflation target was analyzed - which reflects the way the central bank's inflation target is perceived by the public. As part of the analysis, it has been found that a significant part of the development of the inflation cannot be attributed to changes in the target over the course of the past five years. By using this model, we discuss the impact of a major shock over the interpretation of historical developments, and present a proposal for judgmental intervention (discretion), which is based on information which exist outside of the model, and allows for an historical analysis while avoiding the amplified influence of surprises. Such an analysis demonstrates that with the outbreak of the Covid-19 epidemic in the beginning of 2020, the natural rate of interest and the growth rate of the potential output decreased sharply.