The Phillips curve in Israel

Yaacov Lavi and Nathan Sussman
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Yaacov Lavi: Bank of Israel

Israel Economic Review, 2007, vol. 5, issue 1, 93-109

Abstract: In this study we estimate the short-term Phillips Curve for an international panel between 1993 and 2006 and for Israel between 1988 and 2006. The results of the estimation show that the lagged change in the unemployment rate affects the change in inflation. In the international panel the effect is stronger for countries which have achieved price stability. This result reinforced our motivation to examine the stability of the Phillips Curve in Israel. The relationship between the change in the inflation rate and the change in unemployment remained stable over the sample period, even though the lag of the effect became somewhat shorter in duration , and in some formulations the correlation even became stronger. The effect of the change in the exchange rate on the change in the inflation rate was found to be significant only in equations based on the Consumer Price Index (CPI); in equations based on the CPI excluding housing services the effect of the exchange rate was not significant. Finally, the forecasted inflation rate provided by the equation is good. An analysis of the findings indicates that during a period of price stability the short-term Phillips Curve prevails, so that if the Bank of Israel's credibility is based on attaining the inflation target, a counter-cyclical policy should be considered. In view of the fact that the exchange rate does not have an effect on the CPI excluding housing services, the Bank's reaction function should take into account an index of core prices that excludes housing services. This should be done in order to minimize the passthrough between exchange-rate shocks and changes in the Bank of Israel's key interest rate, which could cause real shocks via its effect on the real interest rate.

Date: 2007
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