This paper presents a macro-economic model for a small open economy under a floating exchange rate regime, with monetary policy based on a Taylor-rule and demand determined output in the short run. We used this model as a benchmark for the estimation of a 3sls quarterly model of the Israeli economy between 1990 and 2002. We found evidence of interest rate smoothing by the Bank of Israel and of structural breaks in its setting of the interest rate, in the interest rate's effect on the exchange rate and in the latter's impact on the model's endogenous variables. These breaks which differentiate among three different policy regimes affected the transmission mechanism of the monetary policy especially after 1997 and are related to the increasing inflation aversion of the Bank of Israel over time and to the gradual transition to a floating exchange rate regime. The dynamic simulations performed indicate that the tightening of monetary policy over time induced a fall in inflation at the cost of a higher output gap. From the impulse response functions comparing the three different regimes transpires that the ability of the Bank of Israel to affect prices in the short run increased after 1997 and was accompanied by higher nominal interest rate volatility. In spite of the increasing inflation aversion of the Bank of Israel, the inflation volatility rose on impact following shocks to the nominal exchange rate and the output-gap after 1997. This was the outcome of the combined effect of three factors, the higher inflation aversion of the Bank of Israel, the rise in the sensitivity of the exchange rate to changes in the interest rate and the shortening of the lag with which the former affect the CPI inflation. In the long-run inflation volatility decreased because of the more aggressive reaction of monetary policy to inflationary pressures after 1997. We also found that when the closure of the output-gap, following shocks, is brought about by changes in the nominal exchange rate shifting the real exchange rate away from equilibrium, then the policy regime changes in 1997 can account for the higher output volatility in response to these shocks.

Keywords: Monetary transmission mechanism, Taylor rules, Phillips curve, Real exchange rate.

JEL Classifications: C32, E27, E31, E52, E61, F32, F41.

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