A Peek into the Governor’s Chamber: The Israeli Case

Abstract

The paper analyzes the rules used by the Bank of Israel (BoI) to set the interest rate from mid-1993 till the end of 2001, after relative price stability had been achieved. Our approach follows the analytical framework developed since the influential contribution of Taylor (1993). We compare three policy type rules: the classic Taylor type, the interest rate parity type and the domestic real interest rate type. We give a positive answer to the question; can the path of the interest rate in Israel be explained by a well-defined policy rule? And conclude that the BoI followed a strict, forward-looking rule with smoothing based on interest rate parity considerations, including strong reaction to exchange-rate shocks. The success of reducing inflation by applying extremely tight monetary policy is exemplified in the Israeli case although our analysis shows that the disinflation process was not fully completed in the sample period, in the sense that the rate of interest did not return to a steady state level consistent with low inflation and low real rates of interest.