Inflationary Expectations in Israel: A Multiple Indicators Approach

Abstract

This article derives unobservable short-term inflationary expectations in Israel from their postulated effects on the velocity of demand deposits and the nominal interest rate. A multiple-indicators model is estimated to assess the impact of inflationary expectations on these variables. The expectations-formation mechanism is estimated using a multiple indicators–multiple causes (MIMIC) model. This methodology allows us to test for the structural stability of the model and estimate the relative variances of the postulated error components. Moreover, this procedure contains a built-in specification test of the chosen expectations-formation mechanism.

KEY WORDS:

• Unobservable variables
• Velocity of demand deposits
• Nominal interest rates
• MIMIC model