A Real Model of the Israeli Economy

This paper presents a real open-economy model of the Israeli economy. The model is designed to perform quarterly macroeconomic forecasts and fiscal policy experiments. This is illustrated by the analyses of pre-announced tax cuts and lowering the public debt target – policies which were adopted during the fiscal consolidation process in Israel during the 2000s. The model is neoclassical in nature, but with some non-standard features such as a liquidity effect on nondurable consumption and on durable goods purchases. It includes dynamic optimization of households and firms, and a government which determines expenditures given exogenous tax rates and a public debt target. The model is estimated using the sample of the last decade. The quantitative results include the following: (i) Announcements of future income tax cuts have a simultaneous expansionary effect via consumer demand, but, at the time of implementation, the necessary cuts in government expenditure have a contractionary effect. (ii) The fiscal multiplier is relatively low, 0.4, a result that stems from the openness of the economy and the substitution between GDP and imports. (iii) The economy is sensitive to external world trade shocks that affect not only exports but also private consumption through the wealth and liquidity effects.