Sharp Disinflation Strategy: Israel 1985

Abstract

Curing hyperinflation Michael Bruno In the summer of 1985 the Israeli government introduced an economic programme aimed at reducing inflation from nearly 500% per annum. This paper sets forth the theoretical background to the plan and assesses progress so far. The astronomical inflation rate was the consequence of two features of the Israeli economy: a large budget deficit, and the full accommodation of inflation in monetary aggregates. Progress has been made at reducing the deficit and the indexation of liquid assets has been ended. Rather than fix a target for the rate of growth of the money supply, the authorities have opted for an exchange rate target on the grounds that the public's desired holdings of cash and bank deposits are likely to be very unstable in such an environment. However, the choice of one nominal anchor for the price level is insufficient. A reduction in inflation is likely to lead to disparate movements in wages and prices because wage and price setting decisions are not synchronized in the economy. This is likely to lead to increased unemployment. To avoid this the authorities have negotiated wage and price controls through an agreed social contract. A programme which involves a rapid adjustment from a very high to a low inflation rate is likely to be more credible politically than one that requires only gradual adjustment. So far the programme seems to have been successful with inflation falling to under 3% per month by the end of 1985 accompanied by only a modest rise in unemployment.