Semi-Structural Model with Household Debt for Israel

Alex Ilek and Nimrod Cohen
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Nimrod Cohen: Bank of Israel

No 2023.03, Bank of Israel Working Papers from Bank of Israel

Abstract: We propose a semi-structural DSGE model for the Israeli economy, as a small open economy, which contains a financial friction in the household sector credit market. Such a friction is reflected in a positive relationship between households’ leverage ratio and their interest rate (credit spread) on debt, as evident in the Israeli data. Our main purpose is to evaluate the implications of such a friction on the implementation of monetary policy and macroprudential policy. Our two main findings are: First, it is important that the monetary policy will react also to developments in the credit market, such as credit spread widening, to increase effectiveness in achieving its main goals of stabilizing inflation and real activity. Second, macroprudential policy may increase the sensitivity of households’ credit spread to their leverage. Thus, this policy can mitigate or even prevent over-borrowing and reduce the risk of a debt deleveraging crisis. Moreover, in a case of demand weakness and debt deleveraging, in addition to accommodative monetary policy, the macroprudential policy may contribute to stimulating demand due to a corresponding reduction in credit spread.

Keywords: Monetary Policy; Household Finance; Financial Friction; Macroprudential Policy; Leaning Against the Wind (LAW) (search for similar items in EconPapers)
JEL-codes: E44 E52 G21 G51 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2023-02
New Economics Papers: this item is included in nep-cba, nep-dge, nep-inv, nep-mac and nep-mfd
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