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Research in Bank of Israel: The Interaction between Monetary and Fiscal Policy: Insights from Two Business Cycles in Israel
An article written by Dr. Kobi Braude of the Research Department, and Dr. Karnit Flug, Deputy Governor of the Bank of Israel, for a conference at the Bank for International Settlements in Basel (BIS) in February, presents a comparison between two periods of significant recession that occurred in Israel in the past decade. The comparison shows that sustained fiscal discipline and credible monetary policy during normal times expand policymakers' range of policy options during times of crisis. During the first recession (2001–03) Israel was forced to adopt contractionary fiscal and monetary policy, while in the second recession (2008–09), policymakers were able to adopt expansionary policy. The difference in terms of the effect of the policy response is sizable: policy measures adopted exacerbated the first recession but contributed to easing of the second recession.
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Over the last decade Israel experienced two significant business cycles (Figure 1). The monetary and fiscal policy response to the recession at the end of the decade was very different from the response to the recession of the early 2000s. In the earlier episode, following a sharp increase in the budget deficit, and a reduction of the interest rate by two percentage points in one move, policy makers were forced to make a sharp reversal and conduct a contractionary policy in the midst of the recession. In the second episode, monetary and fiscal expansion was pursued until recovery was well under way (Figure 2). This article examines the factors behind the difference in the policy response to the two recession episodes.

The analysis shows that the credibility of monetary and fiscal policy on the eve of the last recession, along with other factors, played an important role in allowing the Bank of Israel to pursue a highly expansionary monetary policy, which helped to moderate and shorten the recession. In particular, the continued decline in the public debt-to-GDP ratio in the years before the recession allowed the deficit to increase during the recession (through the operation of the automatic stabilizers) with relative stability in yields. In contrast, the poor fiscal situation that preceded the previous crisis and overly sharp interest rate reduction, which proved unsustainable, not only prevented monetary easing during that crisis; they actually forced the central bank to raise its interest rate in the midst of the crisis and the government to cut expenditure (after government bond yields rose to very high levels – Figure 3), which exacerbated the recession. A rough estimate indicates that the difference between the two periods in terms of policy effect on GDP was 2.5 percent of GDP: in the first recession, the contractionary policy cut 1.5 percent from GDP, while during the second recession, the expansionary policy contributed about one percent of GDP.

Israel's experience during the two recessions provides an interesting example of the interaction between fiscal policy and monetary policy, and of the conditions required for allowing counter-cyclical policies. The main lessons are that favorable initial conditions and sound macroeconomic policy in normal times expand the range and variety of policy options available to policy makers during a crisis.
In this article we focused on fiscal and monetary policy but the lesson applies more generally: Good policy in good times pays off handsomely in bad times. Good policy in this respect means monetary policy which promotes price stability, and sustained fiscal discipline during the upside of the business cycle, which credibly aims at an acceptable level of the public debt-to-GDP ratio and pursues a steadily declining path of this ratio over time. Such policy is awarded by the tolerance of financial markets to fiscal and monetary expansion during a recession: yields, risk premia and the exchange rate remain reasonably stable as the central bank reduces the interest rate and as the government allows the automatic stabilizers to operate, temporarily increasing the budget deficit and the public debt. Our calculation shows that the effect on GDP of such a policy response can be significant.