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David Elkayam, Alex Ilek - Bank of Israel


Published at the Advances in Econometrics, (2009) Vol. 24, 61-89
Measurement error: Consequences, Applications and Solutions,
Jane M. Binner, David L. Edgerton, Thoma Elger, Editors
Abstract*
In this paper we analyze the information content of data on inflationary expectations derived from the Israeli bond market. The results indicate that these expectations are unbiased and efficient with respect to the variables considered. In other words, we cannot reject the hypothesis that these expectations are rational.
The existence of continuous data of this type, which is unique to the Israeli economy, enables us to test a number of hypotheses concerning the nature of price adjustment. The study found that expected inflation is a primary factor in the explanation of current inflation. This result is in agreement with the neo-Keynesian approach according to which the adjustment of prices is costly and as a result price increases in the present are determined primarily by expectations of future price increases. It was also found that inflation in Israel is better explained by the neo-Keynesian approach than by the Classical approach or the 'lack of information' approach according to which current inflation is determined by past, rather than current, inflationary expectations.
Another issue examined in this study is whether inflationary inertia existed in Israel during the 1990s. From conventional estimation of an inflation equation (i.e. using future inflation as proxy for expectations) one can get the impression that there was strong inflationary inertia during this period. However, when data on inflationary expectations from the bond market were used in the estimation, this inertia (i.e. lagged inflation) became negative (and insignificant). This finding raise the possibility that inflationary inertia that is found elsewhere is not a structural phenomenon but an outcome of lack of reliable data on inflationary expectations.

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* This is a revised version of our 2004 paper. This version was prepared for the International Conference - Measurement Error, Econometrics and Practice, July 9-11 2007, Aston Business School, Aston University. We would like to thank Edward Offenbacher and Meir Sokoler for helpful comments. The views expressed in this article do not necessarily reflect the position of the Bank of Israel.
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