Israel’s Transition to Inflation Targeting and Exchange Rate Flexibility: Key Lessons

Israel’s transition from a fixed-but-adjustable exchange-rate anchor to an inflation-targeting regime with full exchange-rate flexibility offers important lessons for emerging economies undergoing similar processes. This paper documents the key stages of that transition, emphasizing the coexistence —and eventual incompatibility— of a crawling exchange-rate band with an evolving inflation-targeting framework for monetary policy. We highlight four central empirical findings: the rapid and persistent disinflation from double-digit rates to price stability; the gradual widening and eventual elimination of the exchange-rate band; the sizable quasi-fiscal costs arising from sterilized interventions during the mid-1990s; and the marked decline in exchange-rate passthrough to prices as credibility improved. The Israeli experience suggests that partial exchange-rate management under free capital mobility generates policy trade-offs that can hinder the effectiveness of monetary policy. A fully flexible exchange rate, in contrast, strengthened the credibility of inflation targeting and supported sustained macroeconomic stability. The paper draws broader implications for economies contemplating similar “exit strategies” from intermediate exchange-rate regimes.