Interest Rate Determination and Liberalization of International Capital Movements: Israel 1973-1990

At present, Israel is engaged in a liberalization program which aims to allow more options and flexibility in foreign currency transactions and thus to strengthen the link between the domestic financial market and world markets. The purpose of this study is to examine how changes in regulation of foreign exchange transactions affected the "actual openness" of the Israeli capital account. The integration between foreign and domestic financial markets is measured via the effect on domestic interest rates of changes in world interest rates and of changes in domestic monetary conditions. The respective influences of these factors are analyzed for various policy regimes during the period 1973-1990. As expected, we find that in the transition between an extremely tight regulation regime to a more liberalized one, the act of liberalization of controls over foreign exchange transactions increases the dependence of the domestic interest rate on world rates. Yet, perhaps surprisingly, we find that no clear difference exists between a partially and a fully liberalized policy regime in terms of the degree of actual integration between the domestic and world financial markets. This surprising finding may reflect that once some financial channels are opened agents find their way around existing regulations. Caution is advisable in interpreting this result since it depends on the specific functional forms assumed in the model, and on the division of the period under study into policy regime subperiods.