IDEAS home Printed from https://ideas.repec.org/p/boi/wpaper/2006.01b.html
   My bibliography  Save this paper

Interest Rate Differentials in a Small Open Economy – Long Run Relationship, the Israeli Case

Author

Listed:
  • Nathan Sussman

    (Hebrew University of Jerusalem)

  • Yossi Saadon

    (Bank of Israel)

Abstract

In this paper we develop a model of uncovered interest-rate parity that assumes risk adverse individuals and takes into account not only the expected interest rate but also exchange-rate risk and the liquidity premium. We estimate the model after the opening of Israel’s economy to capital flows, and show that as a long-term relationship, there is parity between the uncovered interest rate spread and the expectations on the change of the exchange rate as derived from the ‘long-term’ equilibrium relationship of relative purchasing power parity. The interest-rate differential between Israel and the US is also affected by changes in exchange rate risks, as measured by the standard deviation of dollar options, and by a liquidity premium. In the period of disinflation––up to 2000––the effect of the expected change in the exchange rate on the interest-rate differential was dominant. From 2000 the contribution of the variables that measure the liquidity premium and the exchangerate-risk premium are the dominant ones in the explanation of the development of the interest-rate differential. Deviations of the interest rate from that derived from the long-term equilibrium apparently lead to a reaction from the Bank of Israel, caused by the pass-through between these deviations and the changes in the exchange rate, that in turn cause deviations in inflation expectations. The process of converging to the long term is estimated to take about eight months.

Suggested Citation

  • Nathan Sussman & Yossi Saadon, 2006. "Interest Rate Differentials in a Small Open Economy – Long Run Relationship, the Israeli Case," Bank of Israel Working Papers 2006.01b, Bank of Israel.
    • Handle: RePEc:boi:wpaper:2006.01b
    as

    Download full text from publisher

    File URL: https://boiwebrepec.azurefd.net/RePEc/boi/wpaper/WP_2006.01.pdf
    File Function: First version, 2006
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
    2. Bruno, Michael, 1993. "Crisis, Stabilization, and Economic Reform: Therapy by Consensus," OUP Catalogue, Oxford University Press, number 9780198286639.
    3. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    4. Cukierman Alex, 1992. "CENTRAL BANK STRATEGY, CREDIBILITY, AND INDEPENDANCE: THEORY AND EVIDENCE: Compte Rendu par Dominique Cariofillo," Journal des Economistes et des Etudes Humaines, De Gruyter, vol. 3(4), pages 581-590, December.
    5. Christina D. Romer & David Romer, 2002. "The evolution of economic understanding and postwar stabilization policy," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 11-78.
    6. Liviatan, Nissan, 1984. "Tight money and inflation," Journal of Monetary Economics, Elsevier, vol. 13(1), pages 5-15, January.
    7. Michael Woodford, 2001. "The Taylor Rule and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 91(2), pages 232-237, May.
    8. Alex Cukierman, 1992. "Central Bank Strategy, Credibility, and Independence: Theory and Evidence," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262031981, April.
    9. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
    10. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-491, June.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Emanuel Barnea & Nissan Liviatan, 2006. "Nominal Anchor: Economic and Statistical Aspects," Bank of Israel Working Papers 2006.01, Bank of Israel.
    2. Akhand Akhtar Hossain, 2009. "Central Banking and Monetary Policy in the Asia-Pacific," Books, Edward Elgar Publishing, number 12777.
    3. P Arestis & A Mihailov, 2009. "Flexible Rules cum Constrained Discretion: A New Consensus in Monetary Policy," Economic Issues Journal Articles, Economic Issues, vol. 14(2), pages 27-54, September.
    4. repec:rdg:wpaper:em-dp2007-53 is not listed on IDEAS
    5. Donato Masciandaro & Davide Romelli, 2019. "Behavioral Monetary Policymaking: Economics, Political Economy and Psychology," World Scientific Book Chapters, in: Behavioral Finance The Coming of Age, chapter 9, pages 285-329, World Scientific Publishing Co. Pte. Ltd..
    6. Singleton,John, 2010. "Central Banking in the Twentieth Century," Cambridge Books, Cambridge University Press, number 9780521899093, September.
    7. Eijffinger, Sylvester C.W. & Hoeberichts, Macro M., 2008. "The trade-off between central bank independence and conservatism in a New Keynesian framework," European Journal of Political Economy, Elsevier, vol. 24(4), pages 742-747, December.
    8. Kuikeu, Oscar, 2011. "Arguments contre la zone franc [Against the cfa franc zone]," MPRA Paper 33710, University Library of Munich, Germany.
    9. Lars P Feld & Volker Wieland, 2021. "The German Federal Constitutional Court Ruling and the European Central Bank’s Strategy," Journal of Financial Regulation, Oxford University Press, vol. 7(2), pages 217-253.
    10. Issing Otmar & Wieland Volker, 2013. "Monetary Theory and Monetary Policy: Reflections on the Development over the last 150 Years," Journal of Economics and Statistics (Jahrbuecher fuer Nationaloekonomie und Statistik), De Gruyter, vol. 233(3), pages 423-445, June.
    11. Cleomar Gomes da silva & Flavio V. Vieira, 2016. "Monetary policy decision making: the role of ideology, institutions and central bank independence," Economics Bulletin, AccessEcon, vol. 36(4), pages 2051-2062.
    12. Masciandaro, Donato & Romelli, Davide, 2015. "Ups and downs of central bank independence from the Great Inflation to the Great Recession: theory, institutions and empirics," Financial History Review, Cambridge University Press, vol. 22(3), pages 259-289, December.
    13. Carl Walsh, 2015. "Goals and Rules in Central Bank Design," CESifo Working Paper Series 5293, CESifo.
    14. Bryan Chapple, 2006. "Monetary policy strategies and credibility - theory and practice," DNB Occasional Studies 404, Netherlands Central Bank, Research Department.
    15. David Archer & Andrew T Levin, 2018. "Robust Design Principles for Monetary Policy Committees," RBA Annual Conference Volume (Discontinued), in: John Simon & Maxwell Sutton (ed.),Central Bank Frameworks: Evolution or Revolution?, Reserve Bank of Australia.
    16. repec:spo:wpecon:info:hdl:2441/f4rshpf3v1umfa09lat09b1bg is not listed on IDEAS
    17. C. Hueng, 2012. "Central Bank Behavior and Statutory Independence," Atlantic Economic Journal, Springer;International Atlantic Economic Society, vol. 40(2), pages 111-126, June.
    18. Philip Arestis & Alexander Mihailov, 2011. "Classifying Monetary Economics: Fields And Methods From Past To Future," Journal of Economic Surveys, Wiley Blackwell, vol. 25(4), pages 769-800, September.
    19. Francisco Rosende, 2002. "La Nueva Síntesis Keynesiana: Análisis e Implicancias de Política Monetaria," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 39(117), pages 203-233.
    20. Adriel Jost, 2018. "Cultural Differences in Monetary Policy Preferences," Working Papers 2018-02, Swiss National Bank.
    21. Otmar Issing, 2010. "The development of monetary policy in the 20th century – some reflections," Working Paper Research 186, National Bank of Belgium.
    22. repec:hal:wpspec:info:hdl:2441/f4rshpf3v1umfa09lat09b1bg is not listed on IDEAS
    23. Qureshi, Irfan, 2015. "Monetary Policy Shifts and Central Bank Independence," MPRA Paper 81646, University Library of Munich, Germany, revised Sep 2017.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:boi:wpaper:2006.01b. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Yossi Yakhin (email available below). General contact details of provider: https://edirc.repec.org/data/boigvil.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.