Journal of Monetary Economics 49 (2002) 1493–1519 Real and nominal effects of central bank monetary policy $ Michael Kahn a , Shmuel Kandel b,c,d , Oded Sarig c,e, * a Bank of Israel, Jerusalem 91007, Israel b Tel Aviv University, Tel Aviv 69978, Israel c Wharton School of the University of Pennsylvania, Philadelphia, PA 19104, USA d CEPR, Switzerland e Arison School of Business, IDC, Herzliya 46150, Israel Received 8 December 1998; received in revised form 13 September 1999; accepted 24 October 2001 Abstract We examine the impact of monetary policy using Israeli data on nominal and indexed bonds, which allow us to decompose nominal interest rates into inflation expectations and ex ante real interest rates. We find that a monetary policy shock, introduced by raising the overnight rate the Bank of Israel charges member banks, raises real interest rates but lowers inflation expectations. Long-term real interest rates are less impacted than short-term rates. Lastly, monetary shocks affect the exchange rate between the Israeli currency and the US dollar. Our estimates are robust to numerous modifications to the basic VAR model. r 2002 Elsevier Science B.V. All rights reserved. JEL classification: E4; E5 Keywords: Monetary policy; Real interest rates; Inflation expectations $ We thank Yakov Amihud, Alex Cukierman, seminar participants in the CEPR Summer Symposium in Gerzensee, Copenhagen Business School, Hebrew University, Norwegian School of Management, Tel Aviv University, University of Cyprus, the Econometrics in Tel Aviv meetings and an anonymous referee for helpful comments and suggestions. The opinions expressed in this paper do not necessarily reflect the opinions of the Bank of Israel. *Corresponding author. Arison School of Business, IDC, P.O. Box 167, Herzliya 46150, Israel. Tel.: +972-9-952-7375; fax: +972-9-956-7392. E-mail address: sarig@idc.ac.il (O. Sarig). 0304-3932/02/$-see front matter r 2002 Elsevier Science B.V. All rights reserved. PII:S0304-3932(02)00179-4