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We formulate and estimate a small New Keynesian model for the Israeli economy. Our
goal is to construct a small but still realistic model that can be used to support the
inflation targeting process. The model contains three structural equations: An open
economy Phillips curve for CPI inflation (excluding the housing component), an
aggregate demand curve for the output gap, and an interest parity condition for the
nominal exchange rate. The model is closed with an interest rate reaction function
(Taylor-type rule) and an ad hoc equation for the housing component of the CPI, which is
dominated by exchange rate changes. In the specification of the model we had to pay
special attention to the crucial role of the exchange rate in the transmission of monetary
policy in Israel, which has a direct effect on almost 60 percent of the CPI. The model is
estimated by the GMM method, using quarterly data for the period 1992:I to 2005:IV. In
the estimation of the structural equations we tried to remain as close as possible to the
theoretical formulation by restricting the dynamics to one lag at most. We use the model
to characterize an "optimal" simple interest rate rule. We find that the monetary authority
should respond to an hybrid backward-forward looking rate of inflation and does not
benefit from direct reaction to exchange rate measures.
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