1. The Bank of Israels Monetary Model Prof. Zvi Eckstein Deputy Governor – Bank of Israel 2008 Outlook of the Local and Global Capital Markets

2. The Monetary Decision Process The Governor makes the monthly interest rate decision on the Monday before the last Wednesday in the month. The interest rate is the overnight rate available for all banks (now also to non-bank institutions through REPO) The decision-making process is as follows: 1.Weekly meetings of the narrow forum (heads of departments, Deputy Governor and the Governor). 2.Sunday before the decision, presentation of main economic facts and models in a broad forum attended by economists from various departments. 3.Sunday meeting of narrow forum to discuss the Departments interest rate recommendations. 4.Monday meeting to discuss the background and main factors in the decision.

3. The Models in Use 1.A small reduced form model for inflation and interest rate (quarterly) – Research Department. Output: Inflation and interest rate for 2/3 years 2.An approximate DSGE model for inflation, output gap, exchange rate and interest rate (quarterly) – Monetary Department (presented below). Output: Inflation and interest rate for 2/3 years 3.Monthly inflation forecasting econometric models – various. (Since last year: Monetary Models Forum to analyze and develop models with extensive visitor program)

4. The Quarterly Model

5. Aggregate Demand Equation Households solve an inter-temporal consumption ( C ) problem: This yields the Euler condition (log-linear form): (1)

6. Aggregate Demand Equation (cont.) Assume foreign demand for Israels exports ( x h t ): Assume exogenous demand for government purchases ( g h t ) and investment ( inv h t ). Aggregate resource constraint (added value form): World demand Real exchange rate (2) (3)

7. Aggregate Demand Equation (cont.) Aggregate demand equation (1+2+3): World demand Real exchange rate Real interest rate Output gap Government purchases Investment Consumption Net-export

8. Price Friction or New Keynesian Local producers face menu costs. Minimize quadratic loss function: The optimal flex-price is derived from profit maximization given the production function: Local inputs Imported inputs Deviation of actual price from optimal flex-price Change in actual price

9. Price Friction or New Keynesian (cont.) Yields local price Phillips Curve: Overall CPI inflation ( π c ) is a combination of domestic inflation ( π h ) and imported inflation ( π f ) : We assume dynamic adjustment of the exchange rate pass-through: Relative price of imported inputs Output gap Local inflation Foreign prices + depreciation rate

10. Uncovered Interest Rate Parity The exchange rate is determined by the following UIP: Exogenous risk premium Interest rate spread NIS/$ exchange rate Expected rate

11. Interest Rate by a Taylor Rule The model is closed with a forecast-based Taylor-type rule: Domestic interest rate Long-run real rate Inflation target Year ahead inflation Inflation target Output gap Lagged rate

12. Model Adjustment The model is adjusted to become more compatible with actual dynamics. Lags of the dependent variable were augmented. Example (local Phillips curve): This could be justified by partly adaptive expectations or firms who index their price instead of optimizing. Relative price of imported inputs Output gap Domestic inflation Expected inflation Lagged inflation

13. Estimation The models (Aggregate Demand, Phillips Curve & UIP) were estimated by the GMM method (equation by equation). Quarterly data from 1992-2006. The interest rate reaction function was calibrated.

14. Estimated Equations Fit Phillips CurveIS Curve

15. Within Sample Dynamic Simulation Quarterly CPI Inflation (π c ) Change in Interest Rate (Δi)Nominal Depreciation (Δe) Without UIP Shock Including UIP Shock

16. Using the Model at the Bank of Israel

17. Using the Model at the BoI At the end of December 2006 the BoIs interest rate was 5.0%. Nominal appreciation was pulling inflation down. Using the models concepts, we split inflation outcomes into domestic inflation and imported inflation. This showed that domestic prices were rising at a high rate of 3.4% while imported prices fell by 5.9% pulling the overall CPI downwards.

18. Using the Model at the BoI BoI key rate % Inflation Target % Quarterly inflation Year on year inflation Dollar interest rate At the end of the month the Governor decided the cut the BoI rate by 0.5 percentage points to 4.5%. January Interest Rate Decision

19. Using the Model at the BoI At the end of April 2007 the BoIs interest rate was 4.0%. Nominal appreciation was pulling inflation down. Domestic prices were rising at a high rate of 4.0% while imported prices fell by 4.9% pulling the overall CPI downwards.

20. Using the Model at the BoI BoI key rate % Inflation Target % Quarterly inflation Year on year inflation Dollar interest rate At the end of the month the Governor decided the cut the BoI rate by 0.25 percentage points to 3.75%. May Interest Rate Decision

21. Using the Model at the BoI At the end of October 2007 the BoIs interest rate was 4.0%. Nominal appreciation had been picking up again since August. On the other hand there were inflationary pressures arising from excess demand and foreign inflation. Domestic prices were rising at a high rate of 4.0%.

22. Using the Model at the BoI BoI key rate % Inflation Target % Quarterly inflation Year on year inflation Dollar interest rate At the end of the month the Governor decided to leave the interest rate at 4.0% November Interest Rate Decision 8.4

23. Interest Rate and Year on Year Inflation Fan Charts % 55% % 33% 47% 20%

24. Thank You