A Semi-Structural Model with Household Debt for Israel

TL;DR

This paper develops a semi-structural DSGE model for Israel incorporating household credit market frictions, highlighting how monetary and macroprudential policies can influence credit spreads, household leverage, and economic stability.

Contribution

It introduces a novel semi-structural DSGE model with financial friction in household credit markets tailored for Israel, analyzing policy implications.

Findings

Monetary policy should consider credit market developments for effectiveness.

Macroprudential policy can reduce over-borrowing and prevent debt crises.

Combined policies can stimulate demand during weak economic periods.

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.