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)| false ( Bruno, Michaeland Sylvia Piterman 1988), “ Israel’s Stabilization: A Two Years’ Review”, in Bruno, Michael, Guido Di Tella, Rudiger Dornbusch, and Stanley Fischer, Inflation Stabilization: Experiences of Israel, Argentina, Brazil, Bolivia, and Mexico( MIT: Cambridge, Massachusetts).
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An earlier version of this paper was presented to a Conference on the Changes in the Structure of the Israeli Economy During the Past Decade: In Memory of Michael Bruno, in Jerusalem on June 6, 1999. The conference volume is forthcoming shortly (in Hebrew).
The inflation rate plotted in Figure 1 is the rate of increase of the CPI, for each quarter, relative to the same quarter a year before.
The overall public sector balance turned from a surplus of 6 percent of GNP in the early 1960s to a deficit of almost 10 percent of GNP at the start of the 1970s due to a sharp increase in military (after the 1967 war), social (education, health, and welfare) and subsidy expenditures.
In particular, the opening of the capital account in 1977–79 which compromised efforts to control domestic credit, the ongoing expansion of export credits (control over which was in part the responsibility of the Ministry of Finance), official steps to stabilize the price of government bonds on the secondary market to lower the cost of borrowing, and maintaining a low discount rate low so the large fiscal borrowing did not crowd out private sector activity.
About half the fiscal adjustment came from revenue increases and half from expenditure declines.
There were labor protests immediately following the announcement of the stabilization program, which initially included a wage freeze. Negotiations resulted not only in the wage adjustments for August and September, but also in an agreement that wages would increase in December, January, and February by 4 percent per month plus a COLA payment of 80 percent of the excess of inflation above 4 percent per month. New wage negotiations would begin in April 1986.
This work was undertaken in cooperation with Phillip Swagel of the IMF.
The price index for underlying nontradable prices excludes the prices of housing and fruit and vegetables, which have been very volatile in the post-stabilization period.
The U.S. guarantee in 1992 on future government foreign borrowing may have also lowered inflationary pressures by providing some assurances of future current account sustainability and reducing borrowing costs (Liviatan and Sussman, 1998).
Recall that this is the operational, i.e. inflation-adjusted, deficit.
If credible—a critical assumption, and a critical goal of monetary policy—an inflation targeting regime can serve as a transparent guide to monetary policy and coordination device in the wage and price setting process and formation of the public’s inflation expectations; see Bufman and Leiderman (1997).
Foreign exchange credit increased from 7 percent of GDP in 1994 to 23 percent of GDP by 1998; shekel-denominated credit as a share in GDP increased from 54 percent to 57 percent in this period.
During 1995–mid-1997, the BoI purchased around $15 billion (as compared with reserves of $7 billion at end 1994), which was sterilized through the monetary deposit facility provided to commercial banks.
While the overall deficit target as a share in GDP was met, the domestic deficit exceeded its target and the foreign surplus was larger than expected. The latter reflected high foreign earnings from official reserves, the level of which increased sharply as the BoI intervened after 1995 to defend the exchange rate band in the face of large capital inflows. The cost to the BoI of sterilizing capital inflows, incurred via interest payments to commercial banks that place funds at the BoI, is not reflected in the definition of BoI profits used in the fiscal accounts.
Interestingly, and as in many other countries, the recent strong and rising FDI flows were not affected by this reassessment.
Note though that nominal deficits would typically decline along with inflation, as nominal interest rates decline.
And it should be noted that this is the operational or inflation-adjusted deficit, which includes only the real component of interest payments on domestic government debt.
It was not until almost four years after the initiation of the program that the COLA was switched from a quarterly to a semiannual payment, indicating the lack of credibility expressed by the private sector in the sustainability of the stabilization effort (Leiderman, 1993).
This is not to criticize the decision not to prevent the real exchange rate from appreciating excessively, which was amply justified—merely to emphasize the lack of alternative policies to maintain pressure to reduce inflation.
While it is sometimes argued that the BoI in practice operates with a medium term path in mind, this lack of transparency for private sector decision making undermines much of the point of an inflation-targeting regime.
See Orsmond (1998) for further details. It is sometimes suggested that the data series in Israel are too short for reliable seasonal adjustment and the creation of an index of underlying inflation; however operating with an imperfect index would be better than ignoring the problem entirely.
Several authors find changes in M1 are a good indicator of changes in inflation (Bufman and Leiderman, 1997), and that the money demand function is fairly stable for the post-stabilization period (see Bufman and Leiderman, 1997 for the period 1989–96; Azoulay and Elkayam 1996; Leiderman and Meron, 1988, and Melnick, 1993).
Testing the one overidentifying restriction gives a χ2 statistic of 0.46, with a p-value of 0.50; the restriction is thus not rejected at a moderate level of economic significance. Allowing a contemporaneous effect of exchange rates on the interest rate does not affect the results.
Similarly Klein (1997) says a 1 percent change in real interest rate reduces domestic demand by 0.2–0.4 percent within a short period.
The relevant supply shocks are changes in import prices and productivity growth and changes in controlled prices such as cancellation of subsidies and devaluation policies not supported by fiscal retrenchment.
Reversing the causation, a 1 percent increase in output has an immediate effect on the price level over the following six quarters, raising it by 0.5 percent over the long run.
A real unit of value (URV) was used for the denomination of prices and contracts until the new currency was introduced, and its value was adjusted daily in terms of the old currency on the basis of estimated inflation. Wages in terms of the URV were set equal to the average of the value over the past four months to deal with variations in real wages over the wage cycle. The URV was also gradually introduced into financial transactions.
In particular, the fiscal balance was shifted from deficit to surplus, prices were deregulated, subsidies eliminated, trade restrictions substantially reduced, the tax structure reformed, public expenditures reduced, and privatization initiated.