Estimation of a Macroeconomic Model for the Israeli Economy

This paper presents a small macroeconomic model for a small and open economy, which allows for an overall assessment and analysis of the state of the economy throughout the business cycle, as well as of its long-term trends. The model is estimated using a combination of Bayesian estimation together with calibration. The results of the estimation reveal that positive supply shocks have characterized the Israeli economy over the last decade, which are reflected in elevated activity, below-target inflation, and an expansionary monetary policy. According to the model, the appreciation in the real exchange rate over the last 15 years stems mainly from long-term structural processes. The development of the implied inflation target was analyzed - which reflects how the central bank’s inflation target is perceived by the public. As part of this analysis, it was found that a significant part of inflation development cannot be attributed to changes in the target over the course of the past five years. Using this model, we discuss how a major shock can impact historical developments and present a proposal for judgmental intervention (discretion), which is based on information that exists outside of the model and allows for historical analysis while avoiding the amplified influence of surprises. Such an analysis demonstrates that with the outbreak of Covid-19 epidemic in early 2020, both natural rate of interest and growth rate of potential output decreased sharply