This study examines the variation in the premium implicit in the yield curve of 12-month Treasury Bills during the period 1992–2002. This premium is measured using a number of econometric methods, one of which allows for the estimated premium to react to uncertainty as measured by the variance of the excess forward return. The findings indicate that during the disinflationary process the premium was characterized by a downward trend which corresponded to the decline in the risk of inflation. During the period from the end of 2000 until the end of 2002, the premium increased as a result of the Intifada which began in the last quarter of 2000 and the crisis of confidence in economic policy which characterized the first half of 2002. The study also examines additional factors that influence the premium. Among those found to have a significant influence were the gap between inflation and the inflation target, the interest rate gap between Israel and aboard, the proportion of Treasury Bills held by the public and the Bank of Israel interest rate (and its standard deviation). This study examines the variation in the premium implicit in the yield curves of 12-month Treasury Bills during the period 1992–2002. This period was characterized by a gradual process of disinflation that eventually led to price stability. Since the premium is not an observable variable, but rather is derived from the forward returns on Treasury Bills, it is estimated using a number of methods. The goal is to analyze its variation over time and to identify the factors that influence it. The estimation of the premium and the analysis of variables that affect it are of critical importance to the management of monetary policy since Treasury Bill yields are currently one of the main indicators used in evaluating the path of the interest rate expected by savers in the economy during the coming year. By neutralizing the changes in the yield curve due to the premium, the path of the interest rate as derived from the yield curve can be more accurately estimated. The method used in this study is consistent with the expectations theory which attributes the structure of the yield curve and its fluctuations to, among other things, individuals’ forecasts of the interest rate (on the assumption that no profits are possible from arbitrage
We propose a semi-structural DSGE model for the Israeli economy, as a small open economy, which contains a financial friction in the household sector credit market. Such a friction is reflected in a positive relationship between households' leverage ratio and their interest rate (credit spread) on debt, as evident in the Israeli data. Our main purpose is to evaluate the implications of such a friction on the implementation of monetary policy and macroprudential policy. Our two main findings are: First, it is important that the monetary policy will react also to developments in the credit market, such as credit spread widening, to increase effectiveness in achieving its main goals of stabilizing inflation and real activity. Second, macroprudential policy may increase the sensitivity of households' credit spread to their leverage. Thus, this policy can mitigate or even prevent over-borrowing and reduce the risk of a debt deleveraging crisis. Moreover, in a case of demand weakness and debt deleveraging, in addition to accommodative monetary policy, the macroprudential policy may contribute to stimulating demand due to a corresponding reduction in credit spread.
This study examines the variation in the premium implicit in the yield curve of 12-month Treasury Bills during the period 1992-2002. This premium is measured using a number of econometric methods, one of which allows for the estimated premium to react to uncertainty as measured by the variance of the excess forward return. The findings indicate that during the disinflationary process the premium was characterized by a downward trend which corresponded to the decline in the risk of inflation. During the period from the end of 2000 until the end of 2002, the premium increased as a result of the Intifada which began in the last quarter of 2000 and the crisis of confidence in economic policy which characterized the first half of 2002. The study also examines additional factors that influence the premium. Among those found to have a significant influence were the gap between inflation and the inflation target, the interest rate gap between Israel and aboard, the proportion of Treasury Bills held by the public and the Bank of Israel interest rate (and its standard deviation).
The rationality test is based on regressing the actual series of variable in period t on its forecast formed in period t − 1. The nonrejection of the rationality hypothesis requires expectations' unbiasedness and efficiency. We show that in a model with t − 1 dating, where expectations strongly and positively affect the economy, the rationality test suffers from low power. It provides a high probability of nonrejection of the rationality hypothesis against numerous alternatives for expectations formation. This result is attained because the realization of the economy is driven by the public's expectations, irrespective of how well they are formed, via the structural relationship between them. The parameters in this test are predetermined by the parameters of the structural model, supporting expectations' unbiasedness under reasonable assumptions. Thus, successfully passing the rationality test could be misleading in terms of interpretation of the quality of the expectations and could lead to questionable accuracy of many applications.
Proponents of Taylor Rules assume that the natural rate of interest is independent of the rate of interest set by the central bank. We use data for Israel to test this hypothesis. We proxy the natural rate of interest by the forward yield to maturity on indexed linked treasury bonds. If the null hypothesis is false it is difficult to suggest persuasive instruments that would identify the causal effect of the money rate on the natural rate of interest. Our identification strategy is therefore built around natural experimentation and event analysis. Large and seemingly exogenous shocks to monetary policy have no measurable effect on the natural rate of interest according to nonparametric and parametric tests. Therefore Wicksell's Classical Dichotomy is empirically valid.
We use a state space model to estimate the time-varying NAIRU for Israel for the period 1992–2011. We specify a forward looking Phillips curve, and use data on inflation expectations derived from the bond market in Israel (breakeven inflation) as a proxy for inflation expectations. This enables us to avoid making an assumption regarding the formation of expectations, especially avoiding the usual practice of assuming adaptive expectations and using lags of inflation as proxies for inflation expectations. We find that the estimated NAIRU is fairly variable and explains a great deal of the low frequency dynamics of the actual unemployment rate. For example, from 2004 to 2011, actual unemployment declined by 6.5 percentage points. Our estimates suggest that 5.5 percentage points (most of the reduction) were due to a decline in the NAIRU. We also found that the estimated NAIRU fits very well in a Beveridge curve, and thus helps to identify the close relationship between job vacancies and unemployment.
We examine the potential effectiveness of asset purchases (AP) in small open economies. To that end we extend the model of Gertler and Karadi (2011) to a small open economy, in which households and firms can borrow and lend in the global. financial market. Our results confirm a previous finding of the literature: In a small open economy, the response of the main variables to AP is weaker than in a closed economy. However, this weaker response does not necessarily imply a weaker benefit of AP: We show that even in a small open economy AP can improve welfare, and that the improvement could potentially be larger than in a closed economy. The reason is that conducting AP allows the economy to restore a more efficient financing structure, in the sense that it reduces intermediation costs paid to foreign lenders.
We study the term premium on nominal and real government bonds in a small open economy within a micro-founded DSGE model with Epstein- Zin preferences. We solve the model using a third-order approximation to allow for time-varying risk premia. We thus extend previous work on closed economies to the case of a small open economy. We find that tech- nological spillovers from the global economy to the small open economy are essential for the ability of the model to produce concurrently a sub- stantial positive nominal term premium, realistic variability of the main macroeconomic variables, and high correlations between the global and domestic economies as evident in the data. We use the model to study the effect of the openness of the economy on bond risk premia. We identify two opposing effects of the openness of the economy on the nominal term premium. The better ability of the open economy to accommodate domes- tic shocks works to decrease the term premium in the open economy. By contrast, in the presence of technological spillovers from the global econ- omy to the small open economy, the foreign technological shock generates a higher term premium in the open economy compared to a closed one. Quantitatively, in our model these effects roughly offset each other so that the term premium in the open economy is similar to the premium in an otherwise similar economy that is closed to trade in goods and financial assets.
In this chapter, we analyze the information content of data on inflationary expectations derived from the Israeli bond market. The results indicate that these expectations are unbiased and efficient with respect to the variables considered. In other words, we cannot reject the hypothesis that these expectations are rational.The existence of continuous data of this type, which is unique to the Israeli economy, enables us to test a number of hypotheses concerning the nature of price adjustment. The study found that expected inflation is a primary factor in the explanation of current inflation. This result is in agreement with the neo-Keynesian approach according to which the adjustment of prices is costly, and as a result, price increases in the present are determined primarily by expectations of future price increases. It was also found that inflation in Israel is better explained by the neo-Keynesian approach than by the classical approach or the “lack of information” approach according to which current inflation is determined by past, rather than current, inflationary expectations.Another issue examined in this study is whether inflationary inertia existed in Israel during the 1990s. From conventional estimation of an inflation equation (i.e., using future inflation as proxy for expectations), one can get the impression that there was strong inflationary inertia during this period. However, when data on inflationary expectations from the bond market were used in the estimation, this inertia (i.e., lagged inflation) became negative (and insignificant). This finding raises the possibility that inflationary inertia that is found elsewhere is not a structural phenomenon but an outcome of lack of reliable data on inflationary expectations.
We propose a simple methodology to estimate the short-term natural rate of interest (NRI) in small open economies. Following Clarida et al.(2002), the NRI depends on the expected growth of (1) domestic potential output and (2) output abroad. We use observable expectations within an estimated central bank's policy rules in Israel, Sweden, and Canada to derive NRI estimates. Our estimates possess strong common dynamics: they fall during crises and rise during booms. Our estimates also imply that monetary policy has been accommodative since the global financial crisis.
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