This Selected Issues paper analyzes the empirical relationship between corporate leverage—and other indicators of financial health—and investment in Israel, using dynamic panel data techniques. The results suggest that weak balance sheets may well have contributed to the investment decline of recent years. The impact of financial variables on investment is more pronounced for firms under financial pressure. However, there is little evidence that weak balance sheets’ impact on corporate investment increases during real downturns or following an equity market bust.


This Selected Issues paper analyzes the empirical relationship between corporate leverage—and other indicators of financial health—and investment in Israel, using dynamic panel data techniques. The results suggest that weak balance sheets may well have contributed to the investment decline of recent years. The impact of financial variables on investment is more pronounced for firms under financial pressure. However, there is little evidence that weak balance sheets’ impact on corporate investment increases during real downturns or following an equity market bust.

III. A Simple Forecasting and Policy Analysis System for Israel Structure and Applications1


Israel has a well-established inflation-targeting framework, but there is scope to improve the analytical structure used to formulate policy and to communicate with the public. In this paper, we develop a simple forecasting and policy analysis system for preparing baseline forecasts and risk assessments for the Israeli economy. The model has been designed to support policy analysis for an inflation-targeting regime and captures the essential small, open, flexible-exchange-rate economy linkages between the policy instrument and output, inflation and the exchange rate. The baseline forecast is largely judgmental in the short term, but uses the model to derive implications for the medium term. We conduct risk assessments on three key sources of uncertainty underlying the baseline forecast: the exchange rate, output gap, and oil prices. We also review briefly some of the issues and methods used in calibrating such a model and in evaluating its properties and performance.

A. Introduction

1. In this paper, we describe a simple forecasting and policy analysis system (FPAS) for preparing baseline forecasts and risk assessments for the Israeli economy. The model has been explicitly designed to support policy analysis for an inflation-targeting regime where the principal objectives are to provide anchors for inflation and inflation expectations.

2. We sketch a simple model complete enough to play this role, a model that captures the essential small, open, flexible-exchange-rate economy linkages between the policy instrument (a short-term interest rate) and the nexus of output, inflation and the exchange rate. The model is in “gap”—or deviation-from-equilibrium—form, and does not try to explain the underlying real equilibrium values. Thus, it cannot address many important issues, such as the dynamic implications of a permanent productivity shock or any stock issues, such as the role of debt. However, the model is capable of addressing many policy issues that arise routinely in making decisions about monetary policy actions and communicating the reasons to the public.

3. To provide some motivation and background information, we follow this introduction with a brief review of economic developments in Israel, with a focus on the past five years, and some of the monetary policy issues that emerge. We return to these themes later in the paper, as we illustrate the potential role of the model by using it to analyze a number of issues that arise in considering the risks to a baseline forecast for the key macroeconomic variables in the Israeli economy.2

4. The details of the results from simulations of any model depend on both its structure and its parameters. The baseline forecast is largely judgmental in the short term, but uses the model to derive implications for the medium term. We also review briefly some of the issues and methods used in calibrating such a model and in evaluating its properties and performance.

B. Some Monetary History

5. Israel’s strong and sustained economic growth experienced since the mid-1980s came to a halt in 2001–02 as a result of the collapse of the high-tech boom, the deterioration in the security situation, and the global slowdown, particularly in U.S. business investment. Israel’s real GDP growth averaged 5.0 percent between 1985 and 2000, after which it contracted by 0.3 percent and 1.2 percent in 2001 and 2002. The economy has since recovered; real GDP grew by 4.4 percent in 2004, and is projected to grow by about 5 percent in 2005 (Figure 1).

Figure 1.
Figure 1.

Real GDP Growth, 1980–2005

(in percent)

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003

6. During most of the pre-millennium period, interest rates were very high in Israel, reflecting the high country risk and a determination to keep inflation under control. The importance of the exchange rate in this regard is clear (Figure 2). With a couple of exceptions, inflation remained low, and, for the most part, stable. The main exceptions were associated with major changes in the exchange rate, which in each case were closely associated with a change in policy stance. The pass-through of the effects of exchange rate changes to the CPI is very fast in Israel; roughly 25 percent of the CPI basket comprises contracts that are denominated in U.S. dollars.3 One can see this effect clearly in the data for 1996, where a sharp increase in rates triggers a strong appreciation in the sheqel and a rapid decline in headline inflation. The experience in 1998–99 is even starker. In part in response to declining inflation, rates were gradually lowered through the early part of 1998. Then rates were cut more deeply, and the sheqel depreciated sharply, with an immediate effect on inflation.4 As the rate of inflation pushed past 5 ercent on a 3-month rolling basis, the policy rate was increased dramatically, which created short-term appreciation and a significant reversal in inflation, with the headline rate dipping into negative territory (3-month rolling basis) in the first few months of 1999. Thereafter, rates began a long, slow decline and inflation remained low and periodically negative. With hindsight, one could argue that policy was perhaps overly cautious in the pace of moving rates towards world levels through this period.

Figure 2.
Figure 2.

NIS/$ Exchange Rate, Headline Inflation, and Bank of Israel’s Policy Rate 1996–2005, 3-month rolling

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003

7. We now review in more detail the period from 2001 to 2003, which echoes the 1998–99 episode. The discussion refers throughout to material presented in Figure 3. In the face of a weakening economy in 2001, the central bank dropped its rate precipitously—200 basis points—towards the end of the year. This exerted significant downward pressure on the sheqel exchange rate through the first half of 2002, which in turn put upward pressure on prices with headline inflation rising sharply through the first half of the year. The subsequent hikes in interest rates, only five months later and by 450 basis points in two steps, only raised questions about the policy intentions and exacerbated the exchange rate depreciation at a time when the weaker sheqel was already reflecting the deteriorating security and recessionary environment.5 Inflation continued to rise, while long-run inflation expectations ratcheted up well above the 3 percent upper level of the target band. With year-on-year inflation reaching over 6 percent by the second half of 2002, and as the economy was struggling to get out of a long recession, the central bank put on the breaks and held its policy rate at around 9 percent until mid-2003. It subsequently lowered interest rates very gradually over the rest of the year. Keeping the policy rate at a high level resulted in a corresponding strong appreciation of the sheqel, which pushed inflation down sharply and into negative territory for a long period in the second half of 2003 and the first half of 2004.

Figure 3.
Figure 3.

NIS/$ Excgange Rate, Headline Inflation, LT Inflation Expectations, and Bank of Israel’s Policy Rate 2001–2005 - monthly year-on-year

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003

8. As reflected in expectations, the credibility of monetary policy was hurt by this episode. Indeed, long-run inflation expectations have fallen to within Israel’s inflation targeting band only in recent months, and then only just, after a long period of hovering above the band, despite the negative rates of inflation.

9. Real GDP growth recovered strongly in 2004 and has accelerated somewhat in 2005. Inflation remains benign, albeit ticking upward within the band, while the unemployment rate continues to fall, but from a high level. The economy remains vulnerable, however, to weakness abroad, especially in the United States and Europe, a sustained rise in oil prices, political volatility, and a deterioration in the security situation. Growth is expected to slow slightly in 2006, primarily owing to lower growth in exports.

10. With renewed emphasis on fiscal consolidation, and inflation within the Bank of Israel’s (BoI) target of 1–3 percent, monetary policy has been accommodative, notwithstanding recent increases in the policy rate. Interest rates were lowered in 2004, as inflationary pressures eased amid sheqel appreciation against the U.S. dollar. For most of 2005, the Bank of Israel kept its policy rate unchanged at 3.5 percent, as inflation remained subdued, with the CPI registering a cumulative rise of 1.8 percent in the first nine months of the year. In September, and again in October, the BoI raised the rate by 25 basis points to 4 percent, and by a further 50 basis points in November, citing the anticipated effects of the cumulative rate of depreciation of the sheqel against the U.S. dollar, partly related to increased political uncertainty, stronger economic growth, and the persistent upward trend in inflation rates world-wide. The BoI increased the policy rate by another 25 basis points in January, 2006, but left it unchanged at 4.75 percent in February.

11. This cursory review of recent monetary history of Israel suggests that there has been excessive volatility in policy intervention with corresponding consequences for the economy and inflation. The evidence from the expectations data suggests that there has been a price to pay on credibility. Better tools may help policy makers better understand the issues they must face and the consequences of their choices. We now turn to one possibility that has been used successfully in many central banks as a starting point—a very simple model of the nexus linking monetary policy, the exchange rate, output and inflation.

C. The Model

12. The model has four core equations: (i) an aggregate demand or IS curve that relates the level of real activity to expected and past real activity, the real interest rate, the real exchange rate and the level of foreign activity; (ii) a price-setting or Phillips curve that relates inflation to past and expected inflation, the output gap, the exchange rate and the relative price of oil6; (iii) an uncovered interest parity condition for the exchange rate, with some allowance for backward-looking expectations; and (iv) a rule for setting the policy interest rate as a function of the output gap and expected inflation.7 The model expresses each variable in terms of its deviation from equilibrium, in other words in ‘gap’ terms. The model itself does not attempt to explain movements in equilibrium real output, the real exchange rate, or the real interest rate, or in the inflation target. Rather, these are taken as given.

Output Gap Equation

13. Domestic output depends on the real interest rate, the real exchange rate, and demand in the rest of the world, represented here by the United States. Dynamics are added through past and future domestic output gaps.8


where ygap is the output gap, RR is the real interest rate in percentage points, z is the real exchange rate (measured so an increase is a depreciation, in percentage points), and a * denotes an equilibrium value of a variable. The output gap is measured as the deviation, in percentage points, of actual output from a measure of the trend or equilibrium level of GDP (a positive number indicates that output is above trend). Finally, ygapust is the output gap in the U.S. economy, similarly measured.

14. For most economies, there are lags in the transmission of monetary policy. In terms of equation (1), this would lead us to expect that the sum of βRRgap and βzgap will be small relative to the parameter on the lagged gap in the equation. Berg, Karam and Laxton (BKL) suggest that that the sum of βRRgap and βzgap is between 0.10 and 0.20 for most economies.9 For Israel, we begin with values at the upper end of this range, since it appears that monetary policy has a relatively rapid effect there.10 BKL opine that the parameter on the lagged gap term, βlag, would typically lie between 0.50 and 0.90. We begin with 0.6, towards the lower end of the range, for the same reason. For the weight on the lead of the output gap, βld, we have picked 0.1, which is in the middle of the range applied for other countries. Together, these settings provide a model economy with moderate inertia, which we would argue is an appropriate characterization of Israel.

15. Consider now the details of the effect of the price variables. Coefficient βRRgap determines the direct effect of the policy variable on the output gap (with a one quarter lag). Our starting point for this value for the Israel model is 0.15, which reflects our view that policy acts quickly and strongly in Israel. This is about three times the size of the parameter picked for a similar model in the Czech Republic, for example.11 For industrial economies, we would expect that βzgap would typically be smaller than βRRgap and would depend on the degree of openness. We have calibrated the model with βzgap at 0.05, one-third the value taken for βRRgap.12 The degree of openness would also influence the relative importance of the direct effect of world excess demand through βyus; normally this effect would be expected to be less than the direct effect of domestic demand conditions. We have set this parameter to 0.15, one-quarter of the domestic (lagged) gap coefficient.

Phillips Curve

16. Inflation depends on expected and lagged inflation, the output gap, the exchange rate gap and movements in the real (relative) price of oil.13


whereπ4te is the expected rate of inflation over the next four quarters. We have a market measure of this expectation for Israel. To close the behavioral model we specify that this expectation is model-consistent:14


17. The Phillips curve embodies some key ideas about the role of monetary policy. The fundamental role of monetary policy is to provide a nominal anchor for inflation and inflation expectations. In equation (2), the coefficients on expected and lagged inflation sum to one, implying that any constant level of inflation is consistent with the output gap and the real exchange rate gap being zero. The equation itself cannot determine a level of inflation. Rather, it is the actions of the monetary authority that pulls inflation towards the target. Monetary policy influences inflation through its effects on output and the exchange rate. Thus, the coefficients on these terms cannot all be zero or monetary policy would have no effect. The dynamic structure of equation (2) has not been formally derived here. However, we show one key idea explicitly. The dynamics of inflation depend on both expectations, per se, and on other sources of inertia. We show that here by having expectations fully model-consistent; yet there is a lagged term in the Phillips curve coming from other sources, such as indexation, regulation or other rigidities from contracts.15

18. The behavior of the economy depends critically on the value of απld. If there is a high weight on the forward component (απld is 1), then inflation is equal to the sum of all future output and exchange rate gaps. A small but persistent increase in interest rates will have a large and immediate effect on current inflation. If on the other hand, there is a lot of inertia (απld is close to 0), then current inflation is a function of lagged values of the gaps, and it may require lengthy periods of monetary pressure to move inflation toward some desired path. Where price setting is flexible and the monetary authorities are very credible, high values of απld might be reasonable, but for most countries values of απld significantly below 0.50 seem to produce results that are considered to be more consistent with data.16 For Israel, we begin with απld at 0.1, that is, with a relatively high degree of inertia in inflation.

19. The value of αygap determines, conditional on the above discussion, the strength of the short-term responsiveness of inflation to excess demand. Economies with more rigidity in price setting (regulation, contracts, etc.) would be expected to have lower values, all else equal.17 We begin with αygap set to 0.3. This applies to a simple moving average of the current and lagged gaps. All else equal, an output gap of 1 percentage point will result in the inflation rate rising by 0.15 percentage points, with a further similar effect next quarter.

20. The value of αz determines the effects of exchange rate changes on inflation, and would typically be larger in economies that are very open. Higher exchange rate pass-through is generally also observed in countries where monetary policy credibility is low and where the value-added of the distribution sector is low. There is evidence of pricing-to-market behavior in many economies, suggesting that αz would be considerably smaller than the import (or traded goods) weight in the CPI basket. Our work suggests that Israel may be an exception in this regard. There are some key prices (rents, for example) that are denominated in U.S. dollars, which provides for fast and powerful pass-through of exchange rate changes into the CPI. Based on preliminary work on this issue, we have set αz to 0.23.

21. The terms in the price of oil,αrpo1πrpote andαrpo2πrpot1e, allow for the direct effect of oil prices on the CPI when the relative price of oil is changing. In a steady state, where oil prices are rising in line with prices generally, these terms would have no effect. When relative oil prices are changing, however, we capture the pass-through effects using current and lagged rates of change. In the Israeli context, both parameters are set to 0.01, which reflects some empirical work to estimate the relevant elasticity.

22. In 2005, and looking ahead to 2006, the effect of changing oil prices emerged as an important issue. To allow for investigation of the implications of pass-through of oil price changes into the core measures of inflation, we add a second Phillips equation, which has similar form, but without the direct effect of relative oil prices included for the headline CPI inflation. Rather, we add a term that allows for a feedback from the difference between headline and core inflation to core inflation itself.


Based on empirical work, αpt is set to 0.05, so that if headline inflation rises one percentage point above core inflation, the latter responds with a one-quarter lag by 0.05 percentage points. The rest of the parameters are the same as in the equation for headline inflation.

Exchange Rate

23. We adopt a version of uncovered interest parity (UIP):


whereRRtus is the U.S. real interest rate and ρ*t is the equilibrium risk premium. As before, RRt is the policy real interest rate and zt is the real exchange rate.18 Thus, any deviation of interest rates from equilibrium, either at home or abroad, would result in the exchange rate deviating from equilibrium, unless such rate deviations were identical. Any other movement in exchange rates is captured in the residual in the exchange rate equation, which can be thought of as a temporary shock to the risk premium.

24. We assume a coefficient of 1 on the interest rate differential, as implied by UIP. This result has been frequently challenged empirically. In defense of our assumption, the simultaneity involving interest rates and exchange rates makes any effort to estimate this coefficient particularly difficult.19 Fundamentally, however, we do not see this as an empirical issue; a macro model with irrational arbitrage is, to say the least, unappealing.

25. We also allow—but do not impose-(model—consistent) rational expectations for the exchange rate:


If δz = 1, we recover Dornbusch (1976) overshooting dynamics. In practice, overshooting often seems to take place in slower motion, and a value of δz somewhat less than 1 may provide more realistic dynamics. Unfortunately, there is little consensus across countries or observers on a reasonable value for δz.20 For the Israel model, we begin with δz set to 0.25.

Monetary policy rule

26. The monetary policy reaction function mirrors the specification in many similar models. The policy instrument is a short-term nominal interest rate, and the central bank sets this instrument to anchor inflation to a target level, π*, over time. The central bank may also temper its actions based on deviations of output from equilibrium.


The structure and parameters of this equation have a variety of implications.21 An important conclusion from assessments of monetary policy in the 1970s, and one embedded in the structure of this model, is that a stable inflation rate requires a positive γπ.22 Beyond this, our framework does not allow explicit discussion of optimality.23 But it may be useful to note that how strongly the authorities should react depends on the other features of the economy. if the economy is very forward-looking, for example, then mild but persistent reactions to expected inflation should be enough to keep inflation close to target. We begin with γπ set at 2.5, which we would characterize as implying fairly aggressive response, but well below what has been used to characterize very aggressive central banks.24 In a similar fashion, we have chosen 0.5 for γygap, which we would characterize as an average weighting.

27. We assume that the central bank smoothes interest rates, adjusting them gradually to the desired value based on deviations of inflation and output from equilibrium. This feature is not easily rationalized, but it is widely observed. We have set this parameter, γRSlag, to 0.5, which is at the low end of the range reported by BKL.

The Supply Side

28. This model has only a rudimentary supply side. Output and the real interest rate appear in all the behavioral equations in gap terms, implying that only deviations from equilibrium levels for output, the real exchange rate and the real interest rate are modeled. The supply-side variables are assumed to follow simple stochastic processes. In applications of the model that are not explicitly stochastic, such as baseline forecasts and policy analysis of specific issues in a forecast, this means that the analyst must make assumptions about the equilibrium levels. Then, output itself will depend on the output gap from equation (1) and equilibrium output:


29. This reflects a choice for simplicity, and in particular recognition that only a much more complicated model would provide a useful supply side. The implications of a positive permanent supply shock for the output gap and inflation, for example, are complex. The increase in capacity may reduce the output gap and prices. On the other hand, an investment boom will tend to result until the capital stock has achieved the higher level of productivity.25 Each key supply-side variable is assumed to depend only on its own lagged values and shocks. This specification serves to provide a set of residuals that can be manipulated so the resulting response of the economy can be examined.

30. Potential output is assumed to grow at some steady-state growth rate, with potentially serially correlated shocks to both the level and growth rate (thus permanent shocks to the level) of potential output. For Israel, we are assuming steady-state annual growth in potential output of 4 percent. The equilibrium real interest rate and the equilibrium real exchange rate are assumed to follow stationary processes, with temporary but possibly persistent shocks around some steady-state level. We assume that the equilibrium short-term real interest rate is 3.5 percent. The equilibrium risk premium is calculated as the value of the risk premium that keeps the real exchange rate on its equilibrium trajectory, given that interest rates are at their equilibrium values. Temporary shocks to the exchange rate are equivalent to and can be interpreted as temporary shocks to the risk premium.

31. The inflation target is assumed to be equal to its lagged value. For Israel, the target inflation rate is set at 2 percent per annum, the mid-point of the Bank of Israel’s 1–3 percent target bands. In a forecasting and policy analysis exercise, the equilibrium values for the domestic real interest rate, the foreign (US) real interest rate, potential output, and the inflation target may come, as usual, from a variety of sources, including judgmental estimates of the authorities or econometric analyses.26

The Rest of the World (United States)

32. Although there is no direct effect of economic conditions in Israel on economic performance in the United States, we include a parallel model of the U.S. economy to provide for sensible dynamics in experiments involving world (US) shocks. The output gap dynamics are represented in a simplified version of equation (1). The structure is the same, but without the exchange rate and world gap terms.


For the baseline analysis, we have assumed that U.S. potential output grows at 3.4 percent per annum over the forecast horizon, falling to 3 percent per annum in the longer term. The dynamic parameters are the same as in the domestic equation.

33. The U.S. Phillips curve has essentially the same structure as the Israeli version, but without the exchange rate effect.


The U.S. target inflation rate is assumed to be 2.5 percent per annum. Note that this implies an ongoing nominal appreciation of the sheqel of 0.5 percent per annum, reflecting the difference in steady-state inflation rates. An important difference between the models comes in our choice for απusld. We set this to 0.2, double the value in the Israeli equation. This makes the U.S. version much more forward-looking, reflecting a view that the Fed has built some credibility in its ability to control inflation. Finally, the parameters on the relative oil price terms are the same as in the domestic equation. There is also an equation for U.S. core inflation, with the same structure to allow for pass-through of oil price shocks into core inflation.

34. Finally, there is a U.S. policy reaction function, which is very similar to the function specified for the Israeli economy, except that some explicit weight is given to the core inflation rate. In the domestic economy, only headline inflation enters the reaction function. We do, however, set the smoothing parameter, γπusld, to 0.75, higher than in the home reaction; the Fed does not, as yet, have a formal inflation target and is seen as less aggressive on this front, period-by-period, than most inflation-targeting central banks. Similarly, γπus, the weight on the key inflation term, is set to 2, a bit lower than in the domestic equation. The weight on the output gap is the same in the two equations.


D. Calibrating the Model and its Properties

35. The answers a model gives depend crucially on the parameter values as well as its structure. How does the analyst choose those values and the details of the structure?27 We have taken and recommended an eclectic approach, following current modeling practice in many policymaking institutions. The basic idea is to choose coefficients that seem reasonable based on economic principles, available econometric evidence, and an understanding of the functioning of the economy, and then to look at how sensible the properties of the resulting model are. An iterative calibration process results in which the properties of the model are examined and changes made to the coefficient values, or the structure of the model, until the model behaves appropriately.

36. Why not just estimate the model econometrically? The answer lies in same logic that leads us to begin with a very simple model, where we choose the structure of the model based on economic and not econometric considerations. For similar reasons, useful parameter values will typically not come from a purely econometric approach. The data are inadequate, time series too short, and structural changes abound. Moreover, for the parameters we need for a simple high-level macro model, the problems of simultaneity in the limited historical data make the identification problem severe.

37. A model should not to be judged primarily by how the parameters are chosen or how well the model fits the data. Rather, the usefulness of a model for policy analysis will depend on how well it captures key aspects of the monetary policy transmission mechanism. For example, the model should provide reasonable estimates of how long it takes a shock to the exchange rate to feed into the price level. Some of this may come from an examination of history, where the analyst identifies a shock based on knowledge of the policy process and traces its effects. For example, a look at past disinflation episodes may shed some light on measures of the historical sacrifice ratio, which, in turn, can guide the calibration of the model. Another approach is to examine the properties of models that have been developed over time in central banks and other policy institutions. In cases where such models are used for day-to-day policy analysis, the results may correspond with the collective judgment of the policymakers and thus may represent a convenient insight into that judgment.28 A comparison with well-established models from similar countries may also be helpful.

38. The main disadvantage of calibration is that it does not lend itself easily to formal statistical inference, which has always been an important priority in both academic and policymaking circles. The use of various system estimation techniques to parameterize Dynamic Stochastic General Equilibrium (DSGE) models and assess their performance is an active area of research.29 Recent developments in the application of Bayesian estimation techniques represent a particularly promising way to bring data and statistical tests to bear in a way that is consistent with the practical approach we suggest.30 These techniques provide answers to the question: to what extent are the data consistent with prior views about parameter values to permit the data to speak in a way that is consistent with the practical approach we suggest.31 However, we do not see the Bayesian approach, or any econometric technique, as an alternative to properties-based calibration. Estimation can provide useful support for calibration, but the primary focus is sensible properties.

E. Using the Model for Forecasting and Policy Analysis

39. Based on the successful experience of a number of central banks that started with a model of the sort we have described above, the model can be very helpful in the process of preparing forecasts and analyzing monetary policy. Typically, the model itself does not make the short-term forecast. That comes from specialists using a variety of tools and information. A variety of techniques are available to enable the model solution to be tuned to a judgmental path for a certain period of time. The model can serve, however, to frame the discussion about the baseline forecast, by ensuring a coherent story. The model also contributes the medium- and long-term part of the baseline, where issues of the conjuncture are resolved in a process of convergence on an equilibrium path.

40. The model comes into its own, however, in evaluating risks to the forecast, appropriate responses to a variety of shocks, and dependencies of the forecast and policy recommendations on various sorts of assumptions about the functioning of the economy. In most central banks that use this FPAS methodology, there will be a lot of sensitivity analysis of this type done before a formal baseline is chosen. Then, some of these experiments will be selected and documented as risks to the baseline scenario. We now illustrate these ideas using our simple model.

F. Baseline Analysis

External Conditions (Table 1)

Oil prices

41. Our baseline assumptions on world oil prices come from the futures market on December 9, 2005. Futures prices see the price of oil falling from 60US$ in 2005Q3 to 56.50 in 2005Q4 and then rising back to 60.10 in 2006Q4. Essentially, the scenario is built on the assumption that the large increase already seen in 2005 is permanent.

U.S. Economy

42. Our U.S. baseline starts from the assumption that the output gap was negative in 2004, but has essentially closed following the strong growth in 2005. Inflation pressure was rising from the output dynamics and is now sharply exacerbated by the oil price shock. Year-on-year headline CPI inflation jumped to 3.8 percent in 2005 Q3, with the quarter-on-quarter measure surpassing 5 percent at annual rates. However, core rates of inflation have remained low. In our baseline scenario, the Fed continues to push up short-term interest rates through 2006. Inflation rises a bit higher but then declines in the second half of 2006 as the effects of the abatement of pressures from the energy price shock and the effects of monetary tightening ease inflation expectations. Our baseline does not include a recession. Output growth slows as it converges on the potential rate, but the output gap remains close to zero. In short, the baseline scenario for the U.S. features quite a soft landing.

Baseline Scenario for Israel (Table 2)

43. After a prolonged period of recession, the Israeli economy is strengthening. To date in 2005, real output growth, year-over-year, has been just over 5 percent. We project growth to be robust in the fourth quarter (5.0 percent, quarterly at annual rates), leaving annual year-on-year growth for 2005 at 5 percent, above potential growth. However, the output gap remains negative, in our view, as recovery in levels still has some way to go before demand conditions become a concern in terms of inflation pressure. Moreover, real output growth is projected to ease slightly going forward, averaging 4.7 percent per for 2006 and 4.4 percent for 2007. We project the output gap to remain negative for the next few years, as the level of output approaches its potential from below.

44. On average, prices fell in Israel in 2004, in large part owing to appreciation of the sheqel against the dollar, and for 2005 as a whole, headline inflation, projected at 1.25 percent, is below the longer-term target rate. However, the sharp rise in oil prices and depreciation in the exchange rate has had significant effects. From 2005 Q2, headline inflation has been well above the target level, with quarter-over-over quarter measure reaching 5.8 percent in Q3.

45. To keep inflation from escalating, especially in the aftermath of the recent depreciation of the sheqel and the large oil price shock, the monetary authority must be vigilant. The short-term rate will have to rise through the final quarter of 2005 and into 2006. Real rates have been below their equilibrium value through the prolonged period of excess supply, but will rise as output approaches its potential level.

G. Risk Analysis

46. In this section, we describe the results for a number of shocks to the baseline assumptions. We begin with a temporary increase in the world price of oil and then turn to demand shocks, considering both an increase in domestic demand and an increase in U.S. demand. Finally, we consider an exogenous depreciation of sheqel, in the form of an increase in the country risk premium.

A Temporary Increase in the Price of Oil (Table 3)

47. Here we assume that the price of oil increases by 50 percent and then gradually returns to the control level over two years. Interest rates rise by 50 basis points on impact and then gradually decline over time. The direct effect of a 50 percent oil price increase would raise headline Y-O-Y inflation by 0.5 percentage points, but the appreciation in the sheqel offsets this direct effect resulting in only a 0.29 percentage point increase in headline inflation on impact. Note that the exchange rate appreciates slowly over time in response to the higher interest rate differential rather than jumping instantaneously in response to the new future path of interest rate differentials.

48. Growth is lower in 2006 by 0.6 percentage points partly because of a negative output gap (-0.2) and partly because of slower growth in potential output growth (-0.4). However, as oil prices decline over time growth increases as both the output gap and the level of potential output return to their baseline line path. Note, that to keep headline inflation from rising significantly core inflation declines below baseline.

An Increase in Foreign Demand (Tables 4 and 5)

49. We next consider a shock to foreign demand, via an add-on/temp shock on the residual in the U.S. output gap equation to 0.5 (i.e., the shock is 0.5 percent of potential) for 3 quarters, starting in the fourth quarter, 2005. Of course, the endogenous response of policy and the rest of the macro variables influence the outcome for the gap over time.

50. In the United States, output rises above control through 2006. Quarterly output growth rises above control for the first three quarters, but then falls below control as the policy response begins to bite. The policy rate is increased relative to control by about 110 basis points on average in 2006, and slightly more in 2007, as inflation continues to rise relative to control through 2007, despite a lower output gap.

51. In Israel, the extra foreign demand raises domestic output, but the effect is muted compared with the direct effects in the foreign economy; the output gap peaks at about 20 basis points above control in the third quarter of the shock. The policy response in Israel is smaller than in the United States, peaking at about 80 basis points. In the very short run an appreciation of the sheqel initially offsets the effect of the shock on inflation, but then inflation rises modestly in response to higher demand.

An Increase in Domestic Demand (Table 6)

52. We next consider a shock to domestic demand, via an add-on shock to the residual in the output gap equation of 0.5 (i.e., the shock is 0.5 percent of potential) for 3 quarters, starting in the fourth quarter, 2005. There are no significant effects of a shock in Israel on the U.S. economy, and discussion is limited to the home country effects.

53. The increase in domestic demand, relative to the baseline, has a negligible concurrent and lagged effect on inflation. In anticipation of upward adjustment in inflationary expectations, monetary policy tightens, with the short rate peaking at about 50 basis points above control in the third quarter of the shock. The sheqel appreciates in response to the tightening, which in the short run more than offsets the direct effect of the additional demand. This illustrates a good example where the policy response to excess demand and the subsequent influence of the exchange rate, along with the degree of inertia in expectations, tend to be fundamental factors. The disinflation environment, associated here with the presence of a negative output gap also plays a key role in mitigating inflationary pressures. Output growth (YOY) reflects the cumulative shock, at about 1 percent, in the second quarter and remains at about the same level above control in the third quarter of the shock. After that, there is a period of decline in output, relative to control, as the policy tightening works to bring inflation and expectations back to the target level.

An Exogenous Depreciation of the Sheqel (Table 7)

54. In this shock, we suppose that the risk premium rises and the sheqel depreciates. The shock is on for just one quarter. The net effect in the first quarter is a depreciation of 1.4 percent. The exchange-rate effects persist for another year, before beginning to subside. Again, while there are some minor effects in the United States, our discussion focuses on Israel. This shock is particularly interesting, given the very recent developments in Israel.

55. This shock puts upward pressure on prices in Israel; annual CPI inflation is up by almost 30 basis points in the first quarter (more than the direct pass-through effect). The policy response is to raise interest rates (60 basis points at the peak) and to keep them higher for a year. The depreciation has little effect on aggregate demand, as the rapid policy response counters any stimulating effect. In the quarterly real growth numbers, we see that there is a very small positive effect in the second quarter, but thereafter the rate increase dominates as the inflationary effects are wrung out of the system.

H. Conclusions and Future Work

56. In this paper we presented a small Forecasting and Policy Analysis System (FPAS) that has been designed to help prepare baseline forecasts and risk assessments for the Israeli economy. The first version of the model was calibrated based on looking at single-equation estimation results, as well as examining the model’s system properties in response to standard demand and supply shocks. Our initial experience using the model as an organizational device has been positive and we plan to use the model on an ongoing basis to provide forecast updates and risk assessments.

57. The paper has benefited from very useful feedback and suggestions at the Bank of Israel and we plan to work with the BoI staff on the issues that were identified over the coming months. First, we plan to estimate the parameters of the model with Bayesian methods and at the same time will attempt to develop a more consistent methodology for measuring key unobservable variables such as potential output and the output gap. Second, we intend to explore the implications of more forward looking behavior in the inflation equations and longer lags between real monetary conditions (combination of the real exchange rate and real interest rates) and the output gap. Finally, using a more structured 2-sector DSGE model as well as empirical work that has been done at the BoI, we plan to extend the baseline to allow for a trend real appreciation in the sheqel.

Table 1:

United States Baseline Forecast on December 10, 2005 Deviations from the Latest Baseline

(percent deviation) or [percentage point deviation]

article image

Inflation, Interest Rates and the Output Gap

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003


Real GDP Growth

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003

Table 2:

Israel Baseline Forecast on December 10, 2005 Deviations from the Latest Baseline

(percent deviation) or [percentage point deviation]

article image

Inflation, Interest Rates and the Output Gap

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003


Real GDP Growth

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003

Table 3:

Israel Temporary 50 Percent Increase in Oil Price Deviations from the Latest Baseline

(percent deviation) or [percentage point deviation]

article image

Inflation, Interest Rates and the Output Gap

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003


Real GDP Growth

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003

Table 4:

United States Results for Positive United States Demand Shock Deviations from the Latest Baseline

(percent deviation) or [percentage point deviation]

article image

Inflation, Interest Rates and the Output Gap

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003


Real GDP Growth

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003

Table 5:

Israel Results for Positive US Demand Shock Deviations from the Latest Baseline

(percent deviation) or [percentage point deviation]

article image

Inflation, Interest Rates and the Output Gap

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003


Real GDP Growth

Citation: IMF Staff Country Reports 2006, 121; 10.5089/9781451819601.002.A003

Table 6:

Israel Results for Positive Demand Shock Deviations from the Latest Baseline

(percent deviation) or [percentage point deviation]

article image