The paper suggests that several factors, besides tight monetary policy, may well have contributed to the high real interest rates that have been observed in Israel. The paper examines the impact of unanticipated changes in nominal interest rate monetary policy shocks on a number of variables in Israel. The paper provides evidence that the inflation expectation measure derived from the capital markets tends to overstate the trend in actual inflation. The paper also provides statistical data on the economic indices of Israel.


The paper suggests that several factors, besides tight monetary policy, may well have contributed to the high real interest rates that have been observed in Israel. The paper examines the impact of unanticipated changes in nominal interest rate monetary policy shocks on a number of variables in Israel. The paper provides evidence that the inflation expectation measure derived from the capital markets tends to overstate the trend in actual inflation. The paper also provides statistical data on the economic indices of Israel.

I. Recent Trends in Israeli Interest Rates: a Look at the Evidence1

A. Introduction

1. The stance of monetary policy, specifically as measured by the level of real interest rates, has been object of lively debate in Israel in the last few years. Some observers contend that monetary policy has been responsible for unnecessarily high real interest rates, whereas others deem that the level of real interest rates is mostly a result of Israel’s sizable public debt and the economy’s inflationary past. The paper intends first to explore the issue of the level of real interest rates in Israel and then to examine what factors have determined recent real interest rate trends. This section provides background on the recent behavior of interest rates in Israel, while Section B presents an empirical analysis of such interest rate trends. Section C contains econometric evidence on real interest rate determination in a broader context, namely a panel of advanced economies in the last 20 years. Conclusions are presented in Section D.

2. The real interest rate, that is, the difference between nominal return on assets and expected inflation, is a key macroeconomic variable affecting (and being affected by) household and firms spending decisions, and also government finances and the balance of payments. As with all real variables, the real interest rate is endogenous and cannot be directly and reliably controlled by the monetary authorities. Yet, policymakers adjust nominal interest rates in order to achieve a desired level of real interest rates, which is consistent with their macroeconomic objectives.2 While it is typically the case that aggregate demand is more responsive to long real rates, in practice central banks control short nominal rates.3 Policy is therefore formulated under the assumptions that: (a) by changing short nominal rates the authorities can affect short real rates; (b) short real rates have a reasonably stable relation with long real rates.

3. The first assumption can be expected to hold empirically, except in economies where inflation expectations are extremely volatile. In high inflation episodes, increases in nominal interest rates are usually perceived as signaling that the authorities expect inflation to rise, rather than as an attempt to raise the real interest rates. That may have been the case in the Latin American hyperinflation episodes or in Israel in the 1980s, but it is not the case in Israel now, as will be seen below. The second assumption is based on the notion that the return on a long-term instrument is the sum of a liquidity premium plus the average short-term interest rates that are expected to prevail over the life of the asset. This assumption has little empirical support, but the evidence suggests that financial markets may have a short-time horizon, so the correlation between ex ante, or expected, short and long real rates is stronger than the one between ex post, actual, short and long rates.4 Moreover, as it is quite difficult to measure long-term expected inflation, construction of series of long real interest rates is not trivial.5

4. Given these elements, it seems reasonable to focus the analysis here on the behavior of short ex ante real interest rates. However, there is no unique real interest rate (or nominal, for that matter) in any given economy, but rather several rates that apply to different maturities, instruments, lenders, and borrowers. Thus, the focus will be on two sets of series, namely short ex ante deposit rates and short ex ante lending rates—data sources are presented in the appendix. Construction of ex ante real interest rate data demands some assumption about expected inflation. While rationality would require agents to use a forward-looking information set in forming inflation expectations, it appears that for most advanced economies expected inflation is at least partly adaptive, in that it tracks closely recent movements in inflation.6 Thus, it was decided to use as expected inflation in period t the centered moving average of actual inflation in t-1, t, and t+1. This assumption is, therefore, consistent with both adaptive and rational, forward-looking expectation hypotheses.7 The work relies on headline CPI inflation, which is more readily available for most countries and is the ultimate object of monetary policy—in addition, the CPI is the relevant deflator in household spending decisions. In sum, the evidence will be examined through analysis of the behavior of short real interest rate series defined as actual, short annual nominal interest rates in month t deflated by expected annual inflation in that period.

5. Figure 1a below shows the behavior of real interest rates in Israel since 1991. The plot includes nominal deposit interest rates (NDIR), expected inflation (EXPI), as defined above, real deposit interest rates (RDIR), and a linear trend line for the real interest rate. Figure 1b is the lending rate analogue. Specifically, nominal deposit rates are rates for short-term sheqel deposits, and lending rates correspond to the overall cost of unindexed sheqel credit. Both figures suggest that nominal rates have not been adjusted automatically to changes in expected inflation, so that the estimated real interest series are quite variable. Moreover, the trend lines indicate that real interest rates have been increasing over time in the 1990s, providing at least partial support to the notion that current interest rates are “high.” The graphs also illustrate the endogenous character of real interest rates, which is particularly clear in the 1998 episode of monetary policy reversal, when nominal rates were raised abruptly in the wake of a sharp increase in inflation expectations which for a while had reduced real rates substantially.

Figure 1a:
Figure 1a:

Nominal and Real Deposit Rates, 1992-1999.

(in percent per year)

Citation: IMF Staff Country Reports 2000, 062; 10.5089/9781451819502.002.A001

Figure 1b:
Figure 1b:

Nominal and Real Lending Rates, 1992-1999.

(in percent per year)

Citation: IMF Staff Country Reports 2000, 062; 10.5089/9781451819502.002.A001

6. The graphs also show that monetary policy, through changes in the discount rate (DISC) that affect deposit and lending rates, has had, at least in the short term, a large impact on real interest rates.8 This point is uncontroversial in Israel, and the empirical analysis of Sections B and C will focus on nonmonetary factors that may contribute, in addition to monetary policy, to determine the recent path of real interest rates.

7. Prima-facie evidence that current real Israeli interest rates are high in both time series and cross-section senses is presented in Tables 1 and 2. Table 1 shows real deposit rates in Israel, its main trading partners, and a group of economies that (in common with the Israeli) have successfully disinflated in the 1990s. Trading partners real rates are weighted according to the scheme used to construct the currency basket that is a key element of Israel’s crawling band regime.9 The set of disinflating economies consists of Chile, Greece, New Zealand, and Portugal.10 Table 2 shows data on real lending rates. The Israeli credit market was deregulated in 1990, so the sample period covered in Table 2 runs from 1991 to the first half of 1999, while Table 1 covers the 1988–99 period.11

Table 1.

Real Short-Term Deposit Interest Rates in Israel and Selected Countries, 1988-99

(In percent per year)

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Sources: Fund staff estimates based on IFS data (see appendix).Note: Monthly average ex ante real interest rates. Inflation expectations assumed to equal a three-month centered moving average of actual annualized CPI inflation. Data for 1999 refer to the first half of the year.

Weights as in the Israeli currency basket.

Difference between Israeli real rates and currency basket real rates.

Simple average of real deposit rates in Chile, Greece, New Zealand, and Portugal.

Table 2.

Real Short-Term Lending Interest Rates in Israel and Selected Countries, 1991-99

(In percent per year)

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Source: Fund staff estimates based on IFS data (see appendix).Note: Monthly average ex ante real interest rates. Inflation expectations assumed to equal a three-month centered moving average of actual annualized CPI inflation.

Weights as in the Israeli currency basket.

Difference between Israeli real rates and currency basket real rates.

Simple average of real lending rates in Chile, Greece, New Zealand, and Portugal.

8. Table 1 shows that real deposit rates in Israel went through three stages in the last 11 years. In the late 1980s, rates were significantly negative, then they increased to close to zero in 1992–94, and became positive and significantly higher in 1995–99. These movements are clearly related to monetary policy shifts and to the trend toward capital account and exchange regime liberalization—in 1993–94 Israel completely liberalized current account payments and capital inflows, and in January 1998 various restrictions on capital outflows were lifted.12 It is interesting to note that, as should be expected, deposit rates in the currency basket economies were m general significantly lower than the rates prevailing in the disinflating economies. The penultimate column in the table presents the real spread (difference) between deposit rates in Israel and the set of industrial economies and shows that, indeed, Israeli rates became higher by about 1995, and increasingly so in 1998, but declined slightly in 1999. The table indicates that interest rates m industrial economies were relatively high in the late 1980s, declined to very low levels in the mid-1990s, and then increased somewhat in the last few years.

9. Israeli lending rates presented in Table 2 replicate the upward trend observed in Table 1 from 1995. Rates were positive throughout the decade, but declined significantly in 1993 and 1994, and then rose sharply. For industrial countries, rates were higher in the later part of the period, while for the disinflating economies real lending rates peaked in the mid-1990s and declined thereafter. The table shows a consistently large positive spread of Israeli lending rates relative to the major industrial economies, and also a substantial increase in Israeli rates relative to the rates observed in the group of disinflating economies.

10. Real lending rates are higher than real deposit rates for all countries and groups of countries presented, as one would expect, but the real banking spread seems higher in Israel than elsewhere—in fact, the average real banking spread in Israel was 2½ times the size of the average spreads prevailing in the United States or the United Kingdom, but not substantially higher than the average spread in disinflating economies. Large banking spreads may be a sign of an uncompetitive credit market, which seems to fit the stylized facts for the Israeli case.13

11. These tables provide some inference on two potential explanations for the increase in Israeli real rates. First, it may have been precipitated by an increase in U.S. real rates from the very low levels observed in the early 1990s. Second, the rise in Israeli rates has been a necessary component of the disinflation process. Information on real deposit rates suggest that indeed, real interest rates m Israel started, after the beginning of the process of exchange and capital account liberalization, to move in line with international trends, especially the United States. Israeli real lending rates also seem to move in line with basket rates in 1995–99. Thus, there is some support for the first explanation. In addition, it is interesting to note that Israeli real rates increased significantly in 1994–95, before the onset of the emerging market difficulties in Asia and Russia, so, although the Russia/LTCM crisis certainly had an impact on the Israeli economy, it does not seem reasonable to explain the high real rates observed in Israel as basically a result of increased risk premia for holding emerging markets’ instruments.

12. An alternative explanation is that the increase in real rates was policy induced. There is certainly evidence that monetary policy played a key role in driving real rates upward since the early 1990s. As can be seen in Figure 2, which plots the nominal discount rate and the real discount rate, that is, the nominal rate deflated by the bond market derived measure of inflation expectations, the Bank of Israel tightened policy quite substantially to contain a resurgence of inflation in 1994, and drove the real discount rate to 3 percent by the end of the year, compared with just ¼ percent in September. Monetary policy was prematurely eased in 1995 and the early part of 1996, and inflation again threatened to accelerate, which prompted a period of renewed and sustained tightening, this time accompanied by fiscal retrenchment, which succeeded m bringing inflation, and inflation expectations, down from about 13 percent in mid-1996 to about 5 percent in mid-1998. In hindsight, it appears that the 1994 tightening was a defensive move, aimed at keeping inflation in the 10 percent neighborhood at which it had settled since 1992, whereas the 1996 tightening represented an aggressive move to complete the protracted disinflation process that had began with the 1985 stabilization program. In the second monetary tightening episode, the real discount rate was kept at 3–5 percent and increased sharply in early 1998 as inflation was declining precipitously. The Israeli economy was thereafter hit by the Russia/LTCM crisis, which prompted a significant depreciation of the sheqel, renewed inflationary pressures, and the consequent monetary policy response, which involved renewed tightening and a quite successfully containment of the pass-through of the depreciation to domestic inflation.

Figure 2:
Figure 2:

Nominal and Real Bank of Israel Discount Rate, 1992-1999

(in percent per year)

Citation: IMF Staff Country Reports 2000, 062; 10.5089/9781451819502.002.A001

13. Cross-section evidence, shown m the last columns of Tables 1 and 2, also suggests that real rates are generally higher in countries undergoing disinflation. This must clearly be the case during the process, but also for some time after inflation has declined to the rates observed in industrial economies, as agents’ inflation memory (and the resulting risk premia required to hold nominal assets) may persist for a protracted period until the credibility of the new low inflation regime becomes firmly entrenched.

14. This section, thus, confirms the notion that in recent years Israeli real interest rates have been high both relative to past levels and to levels observed in other countries. It suggests that increased capital account openness and relaxation of foreign exchange controls may have played a role in explaining the upward sloping real interest rate path, and highlights the clear short-term effect of monetary policy over real interest rates, particularly m the context of the disinflation process.

B. Determinants of Real Interest Rates: Empirical Evidence for Israel

15. There are various theories of the determinants of real interest rates. In the short run, given sticky inflation expectations, real interest rates are mostly determined by changes in monetary policy that affect deposit and lending rates. In the long run, the real interest rate (marginal product of capital) that prevails when the stock of capital is at its steady state level or path, that is, the level that maximizes steady state per capita consumption, is the equilibrium or golden rule real interest rate.14 Whenever actual rates are above (below) this golden rule level they could be deemed too high (low). But the (modified) golden rule rate is itself determined by some key structural parameters, such as the aggregate rate of time preference and long-term population growth.

16. The Wicksellian interest rate theory posits, on the other hand, that market determined interest rates should adjust so as to equate savings and investment at full employment.15 So, in order to examine empirically the (medium- and short-term) determinants of real interest rates, one must analyze developments in the components of aggregate savings and investment. This will be the approach followed below, and follows Blanchard and Summers (1984) and Barro and Sala-i-Martin (1990).

17. A third approach, suggested by Blinder (1996) is to focus on he neutral real interest rate, that is, the rate that equates actual and potential output along the steady state IS curve. This rate would be consistent with constant (not necessarily zero) inflation, and higher (lower) real rates would characterize tight (easy) monetary policy. A difficulty with this concept is that estimating the neutral rate would in principle require solving a full macro-econometric model for the Israeli economy, the construction of which is beyond the scope of this paper. Alternatively, Blinder suggests averaging actual real rates over a long period, including many cycles, such as 30 to 50 years. However, this is not feasible in the case of a country as “young” as Israel, which underwent deep changes in its monetary policy framework in the last ten years and significant structural changes, including massive immigration in the early 1990s. In the following subsections the paper therefore focuses on the golden rule and savings-investment approaches.16

18. This approach does not imply neglect for the role of monetary policy in determining the short-term behavior of real interest rates. Rather, the working assumption is that real interest rate variations that cannot be reasonably explained by domestic nonmonetary factors were caused by either shifts in domestic monetary policy and/or by changes in “world” interest rates.17

The golden rule

19. According to the Solow growth model, the golden rule interest rate is equal to the sum of population growth, growth of “knowledge” or effectiveness of labor, and the rate of depreciation of the capital stock.18 Assuming that technology is constant and abstracting from depreciation, the golden rule interest rate would simply be given by the rate of population growth, and the modified golden rule by the sum of the rates of population growth and time preference.19

20. Interestingly, a rough calculation of the modified golden rule interest rate suggests that indeed one should expect rates in Israel to be higher than in other advanced economies. The reason is that Israel has had a very high (for an advanced economy) rate of population growth, 2.7 percent per year in average, since 1960, compared with just about 1 percent in the United States and Japan, and 0.5 percent in European countries. Table 3 presents estimates of golden rule interest rates for Israel and the countries in the Israeli currency basket. The estimates are just approximations, in that they rely on the assumption of a uniform rate of time preference across countries and time of 2 percent.20 These rough approximations would appear to surface to illustrate the fact that given its high rate of population growth, Israel’s golden rule interest rate will, ceteris paribus, be significantly higher than that observed in most advanced economies.

Table 3:

Comparative Golden Rule Interest Rate Estimates 1960-98

(In percent per year)

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Source: Fund staff estimates based on data from the WEO database.

Rate of population growth plus assumed uniform rate of time preference or 2 percent.

The savings-investment balance

21. Several factors could upset the ex ante balance between savings and investment, thereby causing a shift in real interest rates. Here the effects of changes in public and private saving will be considered, plus the potential effects of changes in profitability.

High real interest rates in Israel: the role of fiscal policy

22. An increase in the fiscal deficit is a natural potential explanation for a negative shift in overall savings. This would appear to be a factor in the case of Israel, which only recently has pursued fiscal consolidation on a sustained basis. Larger public dissaving creates an imbalance that will be reflected in higher real interest rates, given an unchanged monetary policy stance. The effect of a change in the fiscal stance would be larger if the increase is seen as permanent, and even m the case of a transitory widening of the fiscal deficit, real interest rates may fail to decline after the deficit has been reduced if the transitory shock led to a significant accumulation of public debt.21 Such a negative shift in saving raises the expected return of all forms of capital assets, including equities. Thus, one may expect the real stock market return to increase in the future, often, but not necessarily always, through a initial decline in stock prices. Moreover, a larger fiscal deficit is often associated with an increase in the demand for nontradable goods, and can, in the Mundell-Fleming framework, be expected to generate a real exchange rate appreciation.

23. Table 4 presents various indicators of fiscal policy behavior in Israel, including the operational balance, which is used by the authorities in their fiscal policy framework, a cyclically adjusted operational balance, a measure of the fiscal impulse, the conventional (all-inclusive) balance, and the ratios of gross government debt to GDP.22 A negative (positive) fiscal impulse for any given year indicates that policy was tighter (looser) than in the preceding year. Thus, the data in Table 4 indicate that fiscal policy was relatively tight in 1992–93, loose in 1994–95, and tight, in general, since 1996. The fiscal expansion hypothesis seems to be supported by the significant increase in real interest rates in 1995, the second year of the mid-1990s fiscal expansion, and the cycle of real exchange rate appreciation that began by about 1994 (see Table 5). On the other hand, real interest rates continued to increase, albeit modestly, in 1996–97, years of continuous progress in fiscal consolidation. Fiscal policy does not appear to have been a major factor in the increase in real interest rates and the sizeable real exchange rate appreciation observed in those years, as all fiscal policy indicators improved in 1996–97 relative to 1995, in spite of a widening output gap. Fiscal policy continued to be tight in 1998, but even before the August–October sheqel crisis, real interest rates were quite high, namely 6½ percent and 11½ percent, on average, for deposit and lending rates, respectively, in the first seven months of the year. Nevertheless, it is a plausible conjecture that real rates would have declined in the second half of 1998 and 1999 if not for the currency crisis, which forced the Bank of Israel to depart from its policy of monetary easing.

Table 4:

Fiscal Policy Indicators for Israel, 1988-99

(In percent of GDP)

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Sources: Bank of Israel; and Fund staff estimates and projections (based on current policies).

Israeli definition, excludes the nominal component of interest on government debt.

In percent of potential output.

Adjusts revenue and expenditure to account for the impact of the cycle on the operational balance.

Annual change in the cyclically adjusted operational balance (1994 base year).

Includes all interest on government debt.

Table 5.

Indicators of Shifts in the Savings-Investment Balance, 1988-99

(Percentage change relative to previous year, unless indicated otherwise)

article image
Source: WEO database.

Percent of GDP at current prices.

Deflated by the CPI.

Increase indicates real effective appreciation.

24. The evidence is, therefore, mixed. Fiscal policy appears to be a significant factor for the increase of real interest rates in 1994–95, but not in 1996–98. However, the effects of fiscal policy are not immediate, and quantitative empirical analysis of the Israeli economy is constrained by the fact that one cannot observe the interaction of fiscal and monetary policies over several cycles, given the major regime shift implied by the 1985 stabilization program. In this regard, the panel data econometric evidence presented in Section C provides more robust evidence as it relies on a data set that augments the observations for the Israeli economy with information from 27 other advanced economies.

Shifts in private saving and profitability

25. Table 5 shows the behavior of private savings, investment, the stock market, and the real exchange rate. There is apparently a trend towards declining private saving in Israel since the early 1990s. This could be a result of the changed composition of the population in the wake of the very high immigration wave of the early 1990s. Such a trend would certainly create upward pressure on real interest rates. In addition, the infrastructure needs associated with the absorption of the immigrants caused an investment boom m the early to mid-1990s, which would tend to require temporarily, high real interest rates. Data on components of real aggregate demand in Table 6 support the notion that there was a sustained decline in private savings in the 1990s, but this seems to have almost fully compensated for a decline in public consumption, while investment boomed and then tailed off somewhat in the last few years. In any case, net imports of goods and services in real terms increased from an average of 9 percent of GDP in 1988–90 to 17 percent of GDP in 1994–96, reflecting excess domestic absorption. Taken together, these factors suggest that even in the absence of restrictive monetary policies, real interest rates would have trended higher in the 1990s.

Table 6.

Indicators of Shifts in the Savings-Investment Balance, 1988-98.

(Ratios to GDP at 1995 prices)

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Source: WEO database.

26. The stock market boomed in 1991–93, but has behaved in a much more erratic fashion since 1994.23 This indicates that there was no sustained increase in the profitability of Israeli companies, which would have implied an increase in required returns of capital and hence of real interest rates. It is possible that the high-tech sector boom obscured lackluster performance in other sectors, so that on the whole overall profitability remained stable. Aggregate data does not, in sum, support the increased profitability hypothesis, although it must be noted that a proper test of this proposition would probably require analysis of disaggregated data, such as on sector-segmented stock returns.

C. Econometric Evidence

27. The preceding sections examined the role of several factors that may have affected the savings-investment balance in Israel in the 1990s, thereby requiring equilibrium shifts in real interest rates. Although a comprehensive analysis of the determinants of real interest rates is beyond the scope of this paper, inference drawn from a sample of advanced economies would help establish some important “stylized facts” about real interest rate determination and to place the discussion of the Israeli experience in context. The analysis that follows focuses on five possible determinants of real interest rates: profitability, population growth, inflation memory, monetary policy, and fiscal policy (domestic and worldwide).

28. Following Barro and Sala-i-Martin (1990), the econometric analysis is based on a reduced form equation for the ex ante real interest rate which reflects the various factors affecting the national savings-investment balance:


where the alphas and betas are assumed to be positive, and ε and ξ are stochastic error terms. Savings are thus expected to increase with the real interest rate (Rc), the government balance (GOV), and monetary growth (MON), whereas investment is assumed to respond positively to a q-like factor (captured in the second and third elements of equation (2)), population growth (pop), and a term accounting for a country’s inflation history (INF). Under the assumption of imperfect international capital mobility, the real interest rate for a given country is determined by the equilibrium in the domestic market for capital, that is, the equality between savings and investment, which yields the following relation:


where λ = (α1 + β2) and λ1 = (β0 − α0).

29. Profitability is approximated by real stock market returns, STX, and the presumption is that in periods of high actual and expected profits, investment will tend to increase, which will require an increase in real interest rates to induce the formation of additional savings. The lagged real interest rate term enters the equation as the discount factor of profitability in period t-1.24 The discussion in Section B suggests that population growth should have a positive relation with real interest rates—fast population growth stimulates investment and can be associated with a relatively young population, a correspondingly high dependency ratio, and low savings. On the other hand, a history of high inflation may lead agents to demand additional risk premia for holding nominal assets, so the analysis also considers the possible contribution of inflation memory to real interest rates, captured by a moving average of inflation.

30. It is assumed that faster money growth leads to higher expected inflation, erodes the stock of real money, and thus causes an increase in desired saving for a given level of the real interest rate. Finally, in the absence of full Ricardian equivalence, an increase in the fiscal balance leads to higher national savings, and thus to lower real interest rates. As capital mobility across advanced economies has become quite high in the last 20 years, it is reasonable to presume that worldwide fiscal policy shifts would have an impact on domestic real interest rates. In order to assess this possible international transmission effect, the models include measures of worldwide fiscal balance (WFB) as well as domestic fiscal balance (GGB) in the set of regressors.

31. The sample consists of a panel of annual data from 28 advanced economies in the 1979–98 period. The selection of countries reflects the fact that it would seem reasonable to focus the analysis on a group of economies that are similar to Israel’s, although inference from some of the major developing economies could also be interesting. As credit and capital market controls were prevalent, even m advanced economies (and particularly in Israel) in the 1960s and 1970s, the sample period must focus on the last two decades of relative capital market liberalization Most of the data used m the estimation come from the World Economic Outlook (WEO) database—sources and definitions are given m the appendix. STX is simply the nominal increase in a country’s stock market index deflated by consumer prices, POP is the rate of growth of the population in a given country/year, MON is the rate of growth of broad money, assumed to reflect exogenous shifts in monetary policy, GGB is the ratio of general government balance to each country’s respective GDP, and WFB is the ratio of G-7 fiscal balance to GDP. The dependent variable is an ex ante, or expected, real interest rate (RIR), estimated by deflating the yield on long-term bonds by an index of expected inflation (as defined in Section A).

32. Four models were estimated under both the common intercepts and the fixed effects assumptions, namely: a model where the real interest rate is assumed to depend only on structural factors such as profitability, population growth, and inflation memory; a model that tests the influence of worldwide fiscal policy; a model that examines the effects of domestic policies; and a model that combines structural and domestic policy elements. The common intercepts approach ignores cross-section information and is equivalent to treating each country’s data as components of a single augmented “stack” of data. On the other hand, the fixed effects specification allows in restricted estimation of intercepts for each country, but still imposes the restriction that the other regression coefficients are the same across countries.25

33. The results are presented in Table 7. The first model, seen in columns (1) and (5), excludes policy variables, which are included in models (2)–(4) and (6)–(8). Table 7 shows that real interest rates exhibit substantial persistence, which is in line with previous empirical analyses. The results support the notion that profitability has a positive effect on real interest rates, and indicate that inflation memory m particular does appear to have a significant role in determining real interest rates, whereas population growth does not seem to have had any significant impact, although it enters the estimated equations with the expected sign. The domestic fiscal policy variable appears with small but significant negative coefficients in models (3)–(4), and (7)–(8), confirming the presumption that larger surpluses (deficits) contribute to lower (higher) real interest rates. Moreover, international fiscal policy appears to be highly significant (and exhibits the correct sign), which reflects the significant degree of capital mobility prevalent among the economies in the sample. Domestic broad money growth does not appear to have had any impact on long-term real rates, although it is possible that different monetary aggregates could have significant impact in particular countries.

Table 7.

Models of the Ex Ante Long Term Real Interest Rate

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Note: Estimated by generalized least squares with cross-section weights.

34. These results are roughly in line with Ford and Laxton’s (1999) finding that worldwide fiscal policy was a major factor in the increase in real interest rates observed in some OECD countries since the 1970s. However, their analysis focuses on the effect of OECD government debt, whereas here “world” fiscal policy is captured by G7 fiscal balance. The estimates also find evidence of a significant positive relation between corporate profitability and real interest rates, which is consistent with the earlier analysis in both Blanchard and Summers (1984) and Barro and Sala-i-Martin (1990).

35. Clearly, the empirical analysis of real interest rate determination could be refined by considering different proxies for the relevant variables, different estimation methods, and possibly examination of distinct or perhaps augmented samples.26 Yet the estimates included in Table 7 do present support for the proposition that fiscal policy can contribute to reduce real interest rates, and indicate the various real and structural factors, such as profitability and inflationary memory, that affects long-run real rates.

D. Conclusion

36. The paper suggests that several factors, besides tight monetary policy, may well have contributed to the high real interest rates that have been observed in Israel. First, it is not surprising that with capital account liberalization, domestic real interest rates cannot remain negative for a long period and tend to move together with rates observed in the main industrial economies, notably the United States, where real rates appear to have trended upwards in recent years; second, simple golden rule estimates highlight the potential link between high population growth and high real interest rates in Israel; third, fiscal policy seems to have contributed to higher rates in the mid-1990s, but less so in recent years; and fourth, reduced private savings and a temporary investment boom may have contributed to the increase in real interest rates though 1996 and into 1997. But since then, with resumed fiscal restraint, falling investment, moderation of consumption growth, and a slowdown in export growth, tight monetary policy has been the major factor.

37. Econometric estimates for the group of advanced economies suggest that fiscal policy appears to have a significant impact on real interest rates, which is consistent both with the European and the United States experience of the 1990s. The estimates also suggest that profitability and inflationary memory have played a significant role in determining the path of real interest rates.


List of economies included in econometric estimate (samples adjusted for missing observations): Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong SAR, Iceland, Ireland, Israel, Italy, Japan, Korea, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, Taiwan Province of China, the United Kingdom, and the United States.

List of variables:

STX: real stock market return, nominal returns deflated by the consumer price index. Stock market indices are from the IFS database, while CPIs are from the WEO database.

POP: average population growth in 1960–98, from the IFS database.

INF: 10-year lagged moving average of inflation from the WEO database.

WFB: Ratio of G-7 fiscal balances (General Government Balance) to GDP, from the WEO database.

GGB: Ratio of General Government Balance to GDP, from WEO database.

MON: Rate of growth of Broad Money, from WEO database.

RIR: Nominal long-term bond yield, from WEO database, deflated by centered moving average of CPI inflation.


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  • Sacciavillani, Fabio, and Phillip Swagel, 1999, “Measures of Potential Output: An Application to Israel,” IMF Working Paper No. 99/96 (Washington: International Monetary Fund).

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Prepared by Mario Mesquita.


See, for instance. Blinder (1996).


In the case of Israel, the Bank of Israel discount rate.


Barro and Sala-i-Martin (1990). The econometric analysis of Section C will examine the behavior of the real yield on long-term instruments.


Note that if inflation in the short run follows a random walk, then this adaptive behavior is perfectly rational.


Baig and Goldfajn (1998). Moreover, this measure is highly correlated with the bond-market derived measure of inflation expectations to which Israeli central bankers and market analysts tend to attach great importance.


In fact, pairwise Granger causality tests between discount, deposit, and lending rates show that the hypotheses that the discount rate does not Granger cause both deposit and lending rates can be rejected quite comfortably whereas deposit and lending rates do not Granger cause the discount rate. This supports the view that the discount rate has been an exogenous monetary policy instrument.


Specifically, at the end of 1998 the weights were 62 percent for the U.S. dollar, 19.7 percent for the deutsche mark, 4.8 percent for the French franc, 8.2 percent for sterling, and 5.3 percent for Japanese yen.


These countries had double-digit inflation in the 1980s, ranging on average from 12 percent to 21 percent per year, but ended the 1990s with inflation in the low single digits.


Until 1987 Israel had an extensive system of foreign exchange controls, whereby all foreign currency transactions were forbidden unless explicitly permitted.


See IMF Selected Issues paper. Soundness, Profitability, and Structure of the Banking Sector in Israel, IMF Staff Country Report No. 99/40 (1999).


On the golden rule see, for instance, Romer (1996) and Blanchard and Fischer (1989).


The golden rule and savings-investment views are not mutually exclusive, and will indeed be combined in the econometric analysis of Section D.


The presumption is that, over the time horizon that is relevant for economic policy, there is no full convergence of real interest rates across countries, although international trends may sometime be important. This notion is firmly grounded on empirical evidence, see for example, Breedon, Henry, amd Williams (1999).


This is the long-run estimated rate of time preference for the United States. See Lawrence (1991).


Blanchard and Summers (1984). Estimates from MULTIMOD EI indicate that temporary tax cut that increases the U.S. debt/GDP ratio by 10 percentage points implies an increase in the long U.S. real interest rate of about ½ percent in a one to five year interval, and an increase of 10 basis points in steady state.


The fiscal impulse is the first difference of the cyclically adjusted balance.


Note that in 1999 the Tel Aviv stock market indices soared to record levels, in line with the behavior of comparable U.S. indices.


Barro and Sala-i-Martin (1990) indicate that given the difference between average and marginal q, the need to take into account changes in the market value of bonds and the depreciation of capital stocks, and as the stock market does not value portions of a country’s capital stock that are included in total investment, such as residential and public investment, the best estimate of changes in the q variable would depend inversely on the change in real interest rates for a given value of STXt-1.


Thus, both approaches should ideally be used only on data sets that include relatively homogeneous groups of countries.


An interesting approach would be to consider the role of domestic debt. Estimates using the Maastricht ratio of gross debt to GDP did not yield significant results, but it is reasonable to assume that the relevant indicator is net rather than gross debt, as argued by Ford and Laxton (1999). A problem, however, is that it may be difficult to obtain a consistent series of net government debt for all or most advanced economies.

Israel: Selected Issues and Statistical Appendix
Author: International Monetary Fund
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    Nominal and Real Deposit Rates, 1992-1999.

    (in percent per year)

  • View in gallery

    Nominal and Real Lending Rates, 1992-1999.

    (in percent per year)

  • View in gallery

    Nominal and Real Bank of Israel Discount Rate, 1992-1999

    (in percent per year)