| Regulating and directing monetary policy |
| Macroeconomic policy consists of three main components––fiscal policy, a policy to improve the structure of the economy and monetary policy. |
| Fiscal policy, which is set by the government, affects the economy primarily through the national budget––the allocation of government expenditure and its financing via taxation and borrowing. The main variables affected by fiscal policy are the composition of uses in GDP, real interest, and the real exchange rate. |
| The policy to improve the structure of the economy covers the whole range of regulatory and supervisory steps taken in the various sectors intended to create a competitive and efficient business environment. |
| Monetary policy is directed by the Bank of Israel, and is entirely the Bank’s responsibility and the focus of its influence on the economy. The main objective of monetary policy is to achieve price stability and financial stability. In achieving its goals, monetary policy helps to create a business environment that supports sustainable economic growth. The inflation target is what is defined as price stability. Since 1992 the government has set an inflation target as part of its economic policy, and the objective of monetary policy is to reach that target. It does so by determining the level of short-term interest rates on its loans to the banks and deposits from them, and thus, via the financial markets, affects the money supply in the economy. Too low a level of interest would lead to overexpansion and inflationary pressures, while too steep a rise in the rate of interest would result in excessive restraint of economic activity. Monetary policy, through the interest rate, also affects inflation expectations of the public (individuals and companies), as the public make decisions on the basis of their expectations, which are thus eventually self-fulfilling. |
| Past experience in Israel and abroad has shown that inflation has a distorting effect on the vital aspects of the economy––production, consumption, foreign trade, the labor market and the financial markets––to the detriment of stable economic growth. Hence the importance which the Bank of Israel (like central banks all over the world) attaches to the battle against inflation. |
| In the foreign exchange market, against the background of its proper and orderly functioning, the Bank of Israel has adopted a strategy of no direct intervention in the determination of the exchange rate. This means allowing the exchange rate to fluctuate continuously in response to changes in the economic environment, i.e., giving expression to market forces. |
| Since the beginning of the 1990s, liberalization of foreign exchange control has progressed apace, and Israel's economy is now open to free flows of goods and capital. As a result, changes in the domestic and international economic environment will be reflected by the rate of exchange more rapidly than in the past. This obliges policymakers, of both fiscal and monetary policy, to act more responsibly, as the implications of policy for the exchange rate are felt almost immediately. |
| The Monetary Department uses a variety of monetary instruments to implement policy set by the Bank: |
|
Monetary auctions
for deposits from or loans to the banks serve as a major instrument due to the precision and speed of their effect. Through them the Bank of Israel can affect the money supply and the short term rate of interest in the money market, and also prevent undesirable fluctuations in the monetary base resulting from a temporary rise of monetary activities by the government (e.g., tax collection, net borrowing, or domestic payments).
The monetary auctions
offered to the banks are for various fixed periods a day or a week. The Monetary Department decides the amount in the auction, and the banks offer rates of interest they require for those amounts. |
| Overnight loans: Since 1 September 2005 the Bank of Israel has made a window available to the banks for monetary loans, without a quota, at an interest rate 1 percent above the Bank of Israel published rate. The loans are made against collateral, for one day (overnight), and are repaid automatically on the next business day. |
| Overnight deposits: Since 1 September 2005 the Bank of Israel has made a window available to the banks for local-currency deposits, without a quota, at an interest rate 1 percent below the Bank of Israel published rate. The deposits are for one day (overnight), and are repaid automatically on the next business day. |
| The inter-bank market, where banks trade in liquidity among themselves, helps keep the right distribution of liquidity within the system. |
| Makam (the Hebrew acronym for short-term loans) are short term securities (up to one year) issued by the Bank of Israel to affect the monetary base and the rate of interest in the money market. The sale of Makam to the public reduces the monetary base, and thus serves to restrain activity and inflation. The purchase of Makam by the Bank of Israel or their redemption by the public injects money into the market, and thus encourages economic activity. This instrument is similar to the
deposit auctions
, but as the yield is determined by trade on the stock market, it reflects the public's expectations regarding inflation and changes in monetary policy, information which helps the Bank of Israel to plan its future steps. |
| The reserve requirement obliges the banks to deposit with the Bank of Israel a certain proportion of the money deposited with them by the public. Until the beginning of the 1990s, the Bank of Israel used changes in the reserve requirement as an instrument of monetary policy, but it no longer does so, and the level of the requirement is similar to that in the industrialized countries. |
| Derivative financial instruments operated by the Bank of Israel enhance the financial markets, thereby contributing to the improved efficiency of monetary policy, and supplying the Bank of Israel with important information about the public's expectations. These instruments include
Auctions
for the future sales (three months from the date of the auction) of (three-month or one year) Makam. Until 2006 the Bank of Israel also issued NIS/$ options with the purpose of promoting the development of this market; it stopped issuing them when that aim was achieved. |
About the Bank of Israel