The Effect of Fiscal Policy and its Components on GDP in Israel

The Bank of Israel uses two models, one parametric and one non-parametric, to construct a distribution function for the future shekel/dollar exchange rate. The construction of the distribution is based on theoretical developments as described in the literature, adjusted to the market for forex options traded on the Israeli stock exchange. To calibrate the models, the Bank of Israel uses option prices sampled from the order book during the day. This article is the first attempt to use the VAR technique to investigate the effect of fiscal policy in Israel on GDP, aggregate demand in the private sector, private consumption and private investment. The research is carried out using quarterly cross-section data for the period 1986-2008. Among the key findings: *A positive shock of one percent in public consumption is expected to increase GDP by 0.2 percent, aggregate demand in the private sector by 1 percent, private consumption by 0.3 percent and private investment by 1.3 percent. *A positive shock of one percentage point in the statutory indirect tax rate is expected to reduce aggregate demand in the private sector by 1.3 percent, private consumption by 0.6 percent and private investment by 2 percent. In contrast, most of the tests found that a shock in the statutory direct tax rate had no effect on these variables. Various components of public consumption have different effects. A positive shock in government local defense consumption has a moderate but persistence effect, in contrast with a positive shock in civilian government consumption, which has a sharp but short-term effect. A positive shock in public sector purchases has a more persistent and larger effect than that of a positive shock in total public sector salary payments.