the bank of israels monetary model prof. zvi eckstein deputy governor – bank of israel 2008...
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The Bank of Israel’s Monetary Model
Prof. Zvi Eckstein
Deputy Governor – Bank of Israel 2008 Outlook of the Local and Global Capital Markets
The Monetary Decision Process
• The Governor makes the monthly interest rate decision on the Monday before the last Wednesday in the month.
• The interest rate is the overnight rate available for all banks (now also to non-bank institutions through REPO)
• The decision-making process is as follows: 1. Weekly meetings of the “narrow forum” (heads of
departments, Deputy Governor and the Governor).2. Sunday before the decision, presentation of main
economic facts and models in a broad forum attended by economists from various departments.
3. Sunday meeting of narrow forum to discuss the Departments’ interest rate recommendations.
4. Monday meeting to discuss the background and main factors in the decision.
The Models in Use
1. A small reduced form model for inflation and interest rate (quarterly) – Research Department. Output: Inflation and interest rate for 2/3 years
2. An approximate DSGE model for inflation, output gap, exchange rate and interest rate (quarterly) – Monetary Department (presented below). Output: Inflation and interest rate for 2/3 years
3. Monthly inflation forecasting econometric models – various.
(Since last year: Monetary Models’ Forum to analyze and develop models with extensive visitor program)
The Quarterly Model
Aggregate Demand Equation
• Households solve an inter-temporal consumption (C) problem:
• This yields the Euler condition (log-linear form):
0
1
t,, 1
Emaxk
ktk
BBC
Cfttt
tct
ftt
ct
tcttt
ftt
ctt
tt X
P
B
P
B
Pi
B
Pi
BCts
11
)1()1( .
)(1E /11tc
ttttt icc )1(
Aggregate Demand Equation (cont.)
• Assume foreign demand for Israel’s exports (xht):
• Assume exogenous demand for government purchases (gh
t) and investment (invht) .
• Aggregate resource constraint (added value form):
t
f
tht q
wyx
1
World
demandReal exchange
rate
)2(
htg
htinv
htx
htct ginvxcy )3(
Aggregate Demand Equation (cont.)
• Aggregate demand equation (1+2+3):
tttxgctttg
tttxtttcf
xcfc
cttt
cttt
invinvgg
yyqqw
w
iyy
/1/1
/1/1
/1/1
)1(
)1(
)(
)(
World demand
Real exchange rate
Real interest rate
Output gap
Government purchases Investment
Consumption
Net-export
Price Friction or “New Keynesian”
• Local producers face “menu costs.” Minimize quadratic loss function:
• The optimal flex-price is derived from profit maximization given the production function:
0
2/1/
2// )()ˆ(min
0
htt
htt
htt
htt
pppcpp
cht
11 )()(
zf
zf wf
t
whtt ZZY
Local inputs
Imported inputs
Deviation of actual price from optimal flex-price
Change in actual price
Price Friction or “New Keynesian” (cont.)
• Yields local price Phillips Curve:
• Overall CPI inflation (πc) is a combination of domestic inflation (πh) and imported inflation (πf) :
• We assume dynamic adjustment of the exchange rate pass-through:
htzftqty
htt
ht ppbyb /1
ft
cf
ht
cf
ct ww )1(
)( ttft ep
Relative price of imported inputs
Output gapLocal inflation
Foreign prices + depreciation rate
Uncovered Interest Rate Parity
• The exchange rate is determined by the following UIP:
erroriiee tttt tt
/1Exogenous
risk premium
Interest rate
spread
NIS/$ exchange
rate
Expected rate
Interest Rate by a “Taylor Rule”
• The model is closed with a forecast-based Taylor-type rule:
13 ])4([)1( tityTt
ctt
Tttit iyEri
Domestic interest rate
Long-run real rate
Inflation target
Year ahead inflation
Inflation target
Output gap
Lagged rate
14
1
33 c
t
ctc
t PP
Model Adjustment
• The model is adjusted to become more compatible with actual dynamics.
• Lags of the dependent variable were augmented.
• Example (local Phillips curve):
• This could be justified by partly adaptive expectations or firms who index their price instead of optimizing.
htzftqty
htlead
httlead
ht ppbyb 1/1 )1(
Relative price of imported inputs
Output gap
Domesticinflation
Expected inflation
Lagged inflation
Estimation
• The models (Aggregate Demand, Phillips Curve & UIP) were estimated by the GMM method (equation by equation).
• Quarterly data from 1992-2006.
• The interest rate reaction function was calibrated.
Estimated Equation’s Fit
-4
-2
0
2
4
6
8
10
12
14
16
92
94
96
98
00
02
04
06
-25
-20
-15
-10
-5
0
5
10
15
20
25
Residual Fitted Actual
-4
-2
0
2
4
6
8
10
12
14
16
92
94
96
98
00
02
04
06
-28
-24
-20
-16
-12
-8
-4
0
4
8
12Phillips Curve IS Curve
Within Sample Dynamic Simulation
-8-6-4-202468
101214
1999 2001 2003 2005 2007
-3
-2
-1
0
1
2
3
4
5
1999 2001 2003 2005 2007-30
-20
-10
0
10
20
30
40
1999 2001 2003 2005 2007
Quarterly CPI Inflation (πc) Change in Interest Rate (Δi) Nominal Depreciation (Δe)
With
out
UIP
Sho
ck
-8-6-4-202468
101214
1999 2001 2003 2005 2007
-3
-2
-1
0
1
2
3
4
5
1999 2001 2003 2005 2007
-30
-20
-10
0
10
20
30
40
1999 2001 2003 2005 2007
Incl
udin
g U
IP S
hock
Using the Model at the Bank of Israel
Using the Model at the BoI
• At the end of December 2006 the BoI’s interest rate was 5.0%. Nominal appreciation was pulling inflation down.
• Using the model’s concepts, we split inflation outcomes into domestic inflation and imported inflation.
• This showed that domestic prices were rising at a high rate of 3.4% while imported prices fell by 5.9% pulling the overall CPI downwards.
Using the Model at the BoI
Nominal Interest Rate
4.44.5
4.00
4.25
4.50
4.75
5.00
5.25
5.50
5.75
6.00
2006:4 2007:2 2007:4 2008:2 2008:4
BoI key rate
% Inflation
1.1
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
2006:4 2007:2 2007:4 2008:2 2008:4
Inflation Target
%
Quarterly inflation
Year on year inflation
Dollar interest rate
•At the end of the month the Governor decided the cut the BoI rate by 0.5 percentage points to 4.5%.
January Interest Rate Decision
Using the Model at the BoI
• At the end of April 2007 the BoI’s interest rate was 4.0%. Nominal appreciation was pulling inflation down.
• Domestic prices were rising at a high rate of 4.0% while imported prices fell by 4.9% pulling the overall CPI downwards.
Using the Model at the BoI
Nominal Interest Rate
3.63.6
3.00
3.25
3.50
3.75
4.00
4.25
4.50
4.75
5.00
5.25
5.50
2007:1 2007:3 2008:1 2008:3 2009:1
BoI key rate
% Inflation
0.8
-2.0
-1.0
0.0
1.0
2.0
3.0
2007:1 2007:3 2008:1 2008:3 2009:1
Inflation Target
%
Quarterly inflation
Year on year inflation
Dollar interest rate
•At the end of the month the Governor decided the cut the BoI rate by 0.25 percentage points to 3.75%.
May Interest Rate Decision
Using the Model at the BoI
• At the end of October 2007 the BoI’s interest rate was 4.0%.
• Nominal appreciation had been picking up again since August.
• On the other hand there were inflationary pressures arising from excess demand and foreign inflation. Domestic prices were rising at a high rate of 4.0%.
Using the Model at the BoI
Nominal Interest Rate
4.04.0
3.00
3.25
3.50
3.75
4.00
4.25
4.50
4.75
5.00
5.25
5.50
2007:3 2008:1 2008:3 2009:1 2009:3
BoI key rate
% Inflation
1.2
0.0
1.0
2.0
3.0
4.0
2007:3 2008:1 2008:3 2009:1 2009:3
Inflation Target
%
Quarterly inflation
Year on year inflation
Dollar interest rate
•At the end of the month the Governor decided to leave the interest rate at 4.0%
November Interest Rate Decision
8.4
Interest Rate and Year on Year Inflation Fan Charts
%
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
06Q3
06Q4
07Q1
07Q2
07Q3
07Q4
08Q1
08Q2
08Q3
08Q4
09Q1
09Q2
09Q3
09Q4
10Q1
10Q2
55%
%
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
06Q3
06Q4
07Q1
07Q2
07Q3
07Q4
08Q1
08Q2
08Q3
08Q4
09Q1
09Q2
09Q3
09Q4
10Q1
10Q2
33%
47%
20%
Thank YouThank You
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