Measuring the Output Gap and its Influence on The Import Surplus.
This paper reviews some models of central bank intervention in the foreign exchange market in the context of tight monetary policy. It is shown that in a small open economy with capital mobility it is still possible to raise the domestic interest rate, at least temporarily, above the international one if the domestic price level exhibits some rigidity (the “overshooting hypothesis”) or if domestic and foreign bonds are imperfect substitutes. The increase in the domestic interest rate in the context of tight money often involves an increase in the risk premium as a result of the change in the asset portfolio of the public. The risk premium can be derived by using the capital asset pricing model of finance theory. Some illustrations of the change in portfolio are presented using the Israeli experience. The paper concludes with a discussion of diffusing the risk premium in a successful disinflation.