In this paper we estimate a four-equation quarterly structural
VAR model of the Israeli economy during the years 1990-1999. The
estimated system of equations includes an unemployment equation,
an inflation equation, a nominal interest equation describing the
evolution of the interest rate on monetary instruments controlled by
the central bank and a nominal exchange rate equation. We used in
our estimation two identification restriction sets, which allowed us to
differentiate between two structural models. In the first model, model
1, the supply does not respond on impact to changes in aggregate
demand while in the second model, model 2, the supply response is
such that it maximizes the impact effect of demand shocks on
unemployment.
According to our estimation results positive shocks to the BoI
interest rate slow down inflation and are reflected, in both structural
models, in arise in the ex-post real interest rate and in
unemployment. The inflation response to interest rate shocks is
rather fast as a result of the exchange rate response to the changes
in the interest rate. There are no drastic differences between the
estimation results of the nominal interest rate equation in the two
models. In spite of the response of unemployment and inflation to
monetary policy shocks, the variance decomposition results suggest
that the central interest rate variability may be considered as being
the source of a rather small fraction of inflation variability and of an
almost negligible fraction of unemployment variability in both
structural models.
The analysis of the retrieved actual stuctural shows that
deviation of the unemployment rate from its long run equilibrium
level, during the period surveyed, should be attributed, in the context
of model 1, to supply shocks. This is not however the case in model
2. In this model demand and interest rate shocks did also play a
determining role, in addition to supply shocks, in bringing about the
fall in unemployment between 1993 and 1995 and its rise between
1996 and 1999. Indeed the expansion of monetary aggregates
between 1992 and 1994 was very fast, implying an expansionary
monetary policy, while between 1997 and 1998 international trade
growth fell following the crises in emerging markets inflicting an
aggregate demand shock on the Israeli economy. The fact that
model 2 gave rise to an ex-post monetary policy characterization
similar to that supported by out of the model empirical evidence and
that it identified demand shocks which are known to have occurred,
suggests that it may be more suitable than model 1 in describing the
Israeli economy during the period surveyed.
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