[Paper Review] A Semi-Structural Model with Household Debt for Israel

Ilek, Alex, Cohen, Nimrod|arXiv (Cornell University)|Mar 11, 2026

Monetary Policy and Economic Impact0 citations

TL;DR

This paper develops a semi-structural DSGE for Israel with a household credit friction and uses it to assess how monetary and macroprudential policy interact with credit spreads and leverage. It finds policy should respond to credit conditions and that macroprudential tools can mitigateover-borrowing and support demand in weakness.

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.

Motivation & Objective

• Motivate and quantify the role of financial friction in Israel's household credit market within a small open economy framework.
• Construct and calibrate a semi-structural DSGE with a household debt friction inspired by Benigno et al. (2020) and related work.
• Validate the existence of a positive spread-leverage relationship in Israeli mortgage markets.
• Assess how monetary policy and macroprudential policy interact with credit conditions to affect inflation and real activity.

Proposed method

• Two-block structure: a standard SOE core without financial frictions and a closed-economy household credit block with financial friction.
• Adopt a Benigno et al. (2020) style mechanism where household leverage raises the debt spread to lenders.
• Introduce a natural rate of interest that is affected by expected potential output growth and by the credit spread.
• Calibrate key elasticities linking spread to leverage and NRI to spread using Israeli data and related estimates.
• Use a non-microfounded, semi-structural approach with quarterly dynamics and a Taylor-type monetary rule for policy analysis.

Experimental results

Research questions

• RQ1 What are the implications of household debt friction for Israel’s macroeconomy under different shocks?
• RQ2 Should monetary policy react to financial variables such as credit spreads or leverage to stabilize inflation and real activity?
• RQ3 How can macroprudential policy influence credit spreads and borrowing, and what are its effects on demand during debt deleveraging or weakness?

Key findings

• Monetary policy should consider developments in the credit market, such as credit spread widening, to enhance stabilization of inflation and real activity.
• Macroprudential policy can increase the sensitivity of credit spreads to leverage, helping prevent over-borrowing and reducing debt deleveraging risk.
• In scenarios of demand weakness and debt deleveraging, accommodative monetary policy combined with macroprudential tightening can stimulate demand via a reduction in credit spreads.
• The model links financial conditions, via the credit spread, to a negative impact on the natural rate of interest and to inflation and output dynamics, consistent with the financial accelerator literature.