The Inflationary Process in Israel: Shocks and Accommodation

The rate of inflation in Israel increased from 8 percent in 1965 to 300-400 percent in the first half of 1984. The inflationary process until 1977 was not qualitatively different from that in the OECD countries, but after the financial liberalization of 1977 the economy appeared to move into a new era in which the inflation rate seemed capable only of rising. Our explanation of the inflationary process is that because of institutional adaptations, and as a result of accommodating monetary and fiscal policies, the stabilizing forces in the economy are so weak that the inflation rate is in a meta-stable equilibrium. We ascribe the apparent asymmetry of the inflation to the expansionary underlying thrust of monetary and fiscal policy. We develop an analytical framework that assigns roles to indexation, to the financial structure, and to the exchange rate system in determining the dynamics of the economy. We place very little blame for the inflation on wage indexation, which has been incomplete, but we regard the extensive indexation of the returns on financial assets, and the steady shift out of nominal assets, as major contributing factors, for the economy is now left with virtually no nominal anchor. The paper concludes with a brief discussion of alternative stabilization plans, arguing that a successful stabilization program will have to be comprehensive and rapid.