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____________Review____________
Vol. 68, No. 5




May 1986

5 C entral Bank B ehavior and Credibility:
S om e B ecen t T h eo retical
D evelopm ents
18 Adjusting to High Inflation: T he Israeli
E xp erien ce

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F e d e ra l R e se rv e Bank o f St. L ouis
R eview

May 1986

In This Issue . . .




G enerally, ec o n o m ic analysis o f p o licy a ctio n s fo cu se s on th e ir co n se q u e n ce s;
co n sid erab ly less atten tio n h a s b ee n devoted to exam in in g th e re a so n s u n d erly ­
ing th e actio n s taken by p olicym akers. R ecently, how ever, a n u m b er o f stu d ies
have developed m o d els in ten d e d exp licitly to exp lain ce n tra l b a n k behavior. In
th e first article in this Review, “C entral B ank B eh avior an d C redibility: Som e
R ecent T h e o retica l D ev elo p m en ts,” Alex C ukierm an d escrib e s re cen t th eo ries
that show how th e m otives, co n stra in ts an d in form ation o f p o licym akers an d the
p u blic d eterm in e m o n etary p o licy o u tco m es.
C ukierm an ex p lain s th at th e re ce n t th e o retica l litera tu re o n ce n tra l bank
behavior ca n be divided in to positive an d norm ative categ o ries. In th is article, h e
fo cu ses on th e positive th eo ries that are u sed to derive im p licatio n s for both
observable variables (e.g., th e rate o f m o n ey grow th and th e rate o f inflation) an d
unobservable variables (e.g., p o licy credibility).
He show s h o w th e in tera ctio n s b etw een th e p olicym akers an d th e p u b lic ca n
p ro d u ce an in flation ary bias to p o licy a ctio n s. M oreover, C ukierm an also show s
how o n e variant o f th e "p o sitiv e” m od els, th e po litical ap p ro a ch , exp lain s two
o th e r w idely observed p h e n o m e n a asso ciated w ith m o n eta iy p o licy a ctio n s: a
p referen ce for am biguity in p u b lic p o licy p ro n o u n cem e n ts an d large sw ings in
m o n ey grow th an d inflation.

Inflationaiy ep iso d es have o ccu rred in co u n tries th rou gh ou t th e w orld, forcing
th em to resort to varying form s o f in flation a d ju stm en t. T h e a d ju stm en t o f th e
Israeli eco n o m y to risin g in flation over th e p ast d eca d e h a s b ee n particu larly
elabo rate. In th e se c o n d article in th is issu e, “A d justing to High Inflation: T h e
Israeli E x p erien ce,” Z alm an F. Shiffer ex am in es th e Israeli re sp o n se to a cc e le ra t­
ing inflation, esp ecially its various form s o f inflation in d exation .
Shiffer d iscu sse s th e gen eral theory o f in flatio n ’s effect on p rice a d ju stm en t an d
th e u se o f ind exatio n . He th e n ex am in es th e sp e cifics o f Isra e l’s ad o p tio n o f p artial
w age in d exatio n an d th e a d ju stm en t o f its tax system to in flation. Finally, th e
au th o r looks at h ow fin an cial an d real a sse t m arkets took advantage o f im p erfec­
tions in th e tax sy stem an d th e g ov ern m en t’s cred it program s.

3




FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1986

Central Bank Behavior and
Credibility: Some R ecent
Theoretical Developments
Alex Cukierman

o

NE o f th e m ost w idely a cc e p te d te n ets o f m o n e­
tary th eo ry is that p e rsisten t inflation is a m on etary
p h e n o m e n o n . A d ee p er u n d erstan d in g o f p e rsisten t
inflation, therefore, m u st u n co v er th e re aso n s for
p ersisten t in creases in th e m o n ey stock. T h is lead s
n aturally to an investigation o f th e m otives an d c o n ­
strain ts facing cen tral b an k ers w ho d ecid e th e co u rse
o f m onetary policy.
R ecen t th eo retical literatu re on th e beh avior of
m o n etary p olicym akers m ay b e divided in to two
b ro ad categ o ries — positive an d norm ative. T h e p osi­
tive literatu re form ulates h y p o th eses abou t th e o b je c ­
tives an d co n stra in ts facing cen tral bank ers an d d e ­
rives im p licatio n s for th e beh avior o f b o th observable
variables (e.g., th e rate o f m o n etary grow th an d th e
rate o f inflation) an d u nobservable variables (e.g., p o l­
icy credibility). T h e norm ative literatu re fo cu se s on
th e issu e o f how , given th e beh avio r o f cen tral bankers,
m on etary in stitu tio n s ca n b e red esig n ed to im prove
social w elfare. B oth ap p ro ach es u se th e sam e gen eral
analytic fram ew ork to m o d el cen tral ban k behavior.
T h is p aper, th e first in a tw o-part survey, fo cu ses on
th e positive a sp e cts o f cen tral ban k behavior, w ith
p articu lar em p h asis on th e ch a racte rizatio n an d th e
d eterm in an ts o f p olicy credibility.

Alex Cukierman is a professor of economics at Tel-Aviv University and a
former visiting scholar at the Federal Reserve Bank of St. Louis. David
J. Flanagan provided research assistance.




POSITIVE APPROACHES TO CENTRAL
BANK BEHAVIOR AND THE
IMPORTANCE OF CREDIBILITY:
AN OVERVIEW
Positive (and norm ative) th e o rie s o f ce n tra l ban k
behavior rely heavily o n th e n o tio n th at u n a n ticip a ted
m o n ey grow th h as tem porary, positive effects o n o u t­
put an d em p lo y m en t as a resu lt eith e r o f th e L ucas
(1973) effect' o r th e ex iste n ce o f lon g -term co n tra cts in
c o n ju n c tio n w ith ex p o st d eterm in atio n o f em ploy­
m en t by lab or d em an d .2T h ey also rely on th e view that
cen tra l bankers have a w ell-d efin ed o b jective fu n ctio n
(preferences) for e co n o m ic stim u latio n an d inflation
w ithin ea ch p erio d as w ell as in tertem p o ral p refer­
e n c e s over co m b in a tio n s o f th o se variables in the
p resen t an d in th e future.
T h e n o tio n o f p o licy cred ib ility is a fu n d am en tal one
b eca u se th e ability o f m o n etary p olicym akers to
achieve th eir future o b jectiv es d ep en d s on th e in ­
flationary ex p e cta tio n s o f th e p u blic. T h e se in ­
flationary ex p e cta tio n s d ep en d , in tu rn, on th e p u b ­
lic ’s evaluation o f th e cred ib ility o f th e m o n etary p o l­
icym akers. F or exam ple, F elln er (1976) an d H aberler
(1980), w ho co in ed th e term “C redibility H yp oth esis,”
have stresse d th at th e le ss cred ib le d isinflationary
p o licies are, th e lo n g er an d th e m o re severe th eir
in terim adverse ec o n o m ic effects will be.

1A recent exposition appears in chapter 3 of Cukierman (1984).
2Fischer (1977), Taylor (1980).

5

FEDERAL RESERVE BANK OF ST. LOUIS

T h e th eo retical literatu re defines cred ibility as the
exten t to w h ich th e p u blic believes th at a shift in p olicy
h as taken p lace w hen , in d eed , su ch a shift h as actually
o ccu rred .3 M ore im portant, to be cred ible, a policy
m u st be co n sisten t, at ea ch stage, w ith th e pu blic's
inform ation about th e objectives an d co n strain ts fac­
ing th e cen tral bank. T h e p u blic w ill n ot believe an
a n n o u n ced policy if it know s th e p o licy is in co m p a ti­
ble w ith th e cu rren t objectives o f policym akers.

MAY 1986

Table 1
The Monetary Policy Game: Basic Model
I. Output Relationship
(1) y = y„ + (m - m«)

II. Social Welfare Function =
Policymaker’s Objective Function

Part o f th e th e o retical literatu re in terp rets th e c e n ­
tral b an k 's o bjectiv e fu n ctio n as a so cial w elfare fu n c ­
tion. In th is ap p roach , th e p o licy m ak er is cast as a
ben ev olent p la n n er w h o se so le c o n c e rn is to m axi­
m ize a w ell-d efin ed so cial w elfare fu n ctio n . A no th er
p art o f th e literatu re in terp rets th e o bjectiv e fu n ctio n
o f th e p o licy m ak er in term s o f p o litical o b jectiv es. In
th is ap p roach , th e im p o rtan ce assign ed to preventing
inflation relative to stim u lating th e eco n o m y d ep en d s
o n th e relative in flu en ce on th e ce n tra l b an k o f th e
p ro -stim u latio n an d an ti-in flatio n ad vocates w ith in
governm en t an d th e private secto r. F orm al m od els
b a se d o n th e so cial w elfare an d p o litical a p p ro a ch es
are sim ilar at tim es; how ever, in terp retatio n s o f th eir
resu lts are qu ite d ifferent d ep en d in g on w h ich a p ­
p ro a ch is u sed . T h erefo re, th e tw o a p p ro a ch es are
d iscu sse d sep arately.

THE SOCIAL WELFARE APPROACH AS
A POSITIVE THEORY OF CENTRAL
BANK BEHAVIOR
T h e so cial w elfare a p p ro a ch is b a se d o n th ree key
re latio n sh ip s. First, th e eco n o m y is o n e in w h ich
deviations o f em p lo y m en t from its n atu ral level are
positively related to u n an ticip ated inflation ; th is ca n
resu lt from eith e r th e e x iste n ce o f a L ucas (1973)-type
sh o rt-ru n Phillips curve o r a F isc h e r (1977)-Taylor
(1980) co n tra ct fram ew ork. Seco n d , th e m o n etary a u ­
th ority h as a so cia l w elfare fu n ctio n th a t gives a
negative w eight to inflation an d a positive w eight to
em p lo y m en t even b ey o n d th e n atu ral rate.4 It ch o o se s
th e rate o f m o n ey grow th and, h e n c e , inflation, over
w h ich it h as p erfect co n tro l, th at m axim izes th e so cial

3Under this definition, a new policy is credible if it is promptly
believed, whether or not the new policy is more or less inflationary
than the old one. This point is made in a related survey by McCallum
(1984).
4The natural rate is the level of employment that would be obtained in
the absence of monetary disturbances. Employment or output
beyond this level contributes to social welfare if distortionary taxes
or other constraints hold employment below its optimal level. An
elaboration appears at the end of this section.

Digitized for
6 FRASER


(2) W = — m2 + 2 (y — y„)
III. Policymaker’s Objective Function in terms of m
(3) W = - m2 + 2 (m - me)
IV. Public’s Utility Function
(4) U = - (m - m8)2

w elfare fu n ctio n .3 Finally, th e p u b lic u n d e rsta n d s th e
cen tral b a n k ’s b eh avior an d form s its inflationary
ex p ecta tio n s accord in gly. Sin ce in flation is “b a d ,” th e
best rate o f m o n eta iy ex p an sio n m u st be zero. T h e re ­
fore, so cial w elfare is m axim ized w h en b o th th e actual
an d ex p ected in flation are zero an d em p lo y m en t is at
its n atu ral level.
Yet, th e relatively sim p le m o d el ju s t d escrib e d is
sufficient to g en erate an inflationary bias; as a result,
social w elfare is low er th a n it w ou ld have b ee n h ad th e
m on etary au th ority b ee n cred ib ly co m m itted to a zero
m o n ey grow th (zero inflation) ru le.6 In e ss e n ce , th e
m o n etary a u th o rities a n d th e p u b lic are ca u g h t u p in a
kind o f "p riso n e rs’ d ilem m a.”

The Prisoners’-Dilemma Aspect o f
Monetary Policy
T h e d ilem m a is illu strated sim ply in th e follow ing
m od el.7 T h e m o n etary a u th o rity a n d th e p u b lic c a n b e
view ed as engaged in a gam e to d eterm in e w h at th e
level o f o u tp u t an d th e rate o f inflation w ill be. T h e
eco n o m y ’s o u tp u t is d eterm in ed by a L ucas-Sargen t
aggregate su pply fu n ctio n as sh o w n in eq u atio n 1 in
table 1, w h ere y is th e a ctu a l level o f output, y n is its

5Short-run discrepancies between the rate of inflation and the rate of
monetary growth are abstracted from, in this discussion, by assum­
ing that those two rates are equal at all times.
6This scenario originated in a well-known example by Kydland and
Prescott (1977) and was elaborated and formulated within an
explicitly dynamic framework by Barro and Gordon (1983b).
T h is model is based on a static reformulation by Backus and Driffill
(1985a).

MAY 1986

FEDERAL RESERVE BANK OF ST. LOUIS

Table 2
Payoff Tables for Basic Monetary
Policy Game
1. Policymaker’s Payoff Table (from equation 3)
Policymaker
chooses(m)

Public expects (me)
0

1

0

0

-2

1

1

-1

II. Public’s Payoff Table (from equation 4)
Policymaker
chooses(m)
0
1

Public expects (me)
0
0
-1

1
-1
0

natu ral level, and m and m" are th e actu al an d ex­
p ected inflation rates, respectively.8 T h e p olicym ak­
e r ’s o bjective fu n ctio n (taken to be id en tical to the
social w elfare function) is show n in eq u atio n 2
(table l).!l
W hen eq u ation 1 is su b stitu ted into 2, th e p o licy m a­
k er’s o bjective fu n ctio n now takes th e form sh o w n in
eq u ation 3 in table 1. Taking m' as given, th e value o f m
th at m axim izes social w elfare is m = 1, resu lting in a
positive inflation rate. T h is o u tco m e can easily be seen
in the m o n eta iy p o licy m ak er’s payoff m atrix show n in
table 2 (I). If th e m o n etary au thority ch o o se s zero
inflation, m = 0, its payoff is eith e r 0 o r —2, d ep en d in g
o n w h eth er m c eq u als 0 o r 1. If it ch o o se s m = l ,
how ever, its payoff is eith e r 1 or — 1, d ep en d in g on
w h eth er m ' equals 0 o r 1. Inflation is clearly th e
d om in an t strategy from th e point o f view o f th e m o n e­
tary au thority; th e payoffs for m = 1 are h ig h er re g a rd ­
less o f what inflation rate the p u blic exp ects.
So far th e analysis h as fo cu se d solely on th e m o n e ­
tary p o licy m ak er’s o bjectiv e fu n ctio n . However, th e
p u b lic also has an objective fu n ctio n ; it is assu m ed to
resist bein g fooled by p olicym akers. T h e p u blic is
a ssu m ed to m axim ize a utility fu n ctio n sim ilar to
eq u ation 4 in table 1, taking m as given. B e ca u se th e
p u b lic know s th e m o n eta iy au th o rity ’s incen tiv e

8Since output and employment are positively related, y can also be
viewed as a proxy for employment.
9The various constants in equations 1 and 2 have been chosen for
simplicity of exposition. The main qualitative point does not depend
on the values of those constants.




stru ctu re, it ex p ects th e m o n etary au th o rity to ch o o se
m = 1; co n seq u en tly, it ch o o s e s m ' = l . 10T h e resu lta n t
o u tco m e is an in ferior solu tion , w ith payoffs o f —1 to
th e m on etary au th ority an d 0 to th e pu blic.
T h e inflationary b ias o cc u rs b e c a u se th e m o n eta iy
au th ority h as th e in cen tive to inflate in o rd er to
in crea se em p loy m en t o n ce th e p u b lic’s in flatio n aiy
ex p e cta tio n s have b e e n set. T h is in cen tive is p re sen t
regard less o f w h eth er th e p u b lic ex p e cts a zero o r a
positive rate o f inflation. B eca u se th e p u b lic reco g ­
n izes th is in centive, it rationally e x p e cts a positive rate
o f inflation; th is forces th e m o n etary au th o rity actu ally
to inflate in o rd er to m ain tain em p lo y m en t at its
n atu ral level. As a result, th e eco n o m y en d s up w ith
th e sam e em p lo y m en t level as u n d e r a zero m on ey
grow th rule, bu t w ith excessive inflation an d low er
w elfare.
B arro an d G ordon (1983b) ch a ra cte riz e th is so lu tio n
as “d iscretio n ary ” b e c a u se th e m o n etary au th ority
can ch o o se w h atever rate o f m o n etary grow th (and,
h en ce, inflation) it d esires. If th e m on etary au thority
h ad b een cred ibly co m m itted to zero m o n ey grow th
(by a co n stitu tio n a l a m en d m en t, fo r exam ple), th e
su p e rio r so lu tio n , m = m° = 0, co u ld have b e e n
achieved . But, in th e a b se n c e o f cred ib le co m m it­
m e n ts on th e p art o f th e policym aker, th e (Nash)
equ ilibriu m to th e p o licy gam e involves positive an d
su b op tim al in flatio n ."

A Dynamic Extension o f the Model
As p o in ted out by B arro an d G ordon (1983b), th e
p riso n e rs’-d ilem m a a sp e ct o f th e policy gam e carries
over to th e ca se in w h ic h th e p o licy m ak er ca res abou t
so cial w elfare in b o th th e p re se n t an d fu tu re period s.
T h is ca n b e illu stra ted by gen eralizin g th e objective
fu n ctio n o f th e p o licy m ak er as sh o w n in eq u atio n 5:
(5) W =

°C
2

m2
P1[Aim, —m f ) ------ £ - ] .

(3 is th e d isco u n t fa cto r a p p lied to fu tu re w elfare in th e
p o licy m ak er’s so cia l w elfare fu n ctio n . T h e term in
b rack ets is th e level o f so cial w elfare a ttain ed in th e ith
p erio d .'2 T h e co n sta n t, A, is th e m arginal rate o f
su b stitu tio n b etw ee n e c o n o m ic stim u latio n an d in ­
flation p rev en tion ; th e larg er A is, th e m o re th e policy-

10This is obtained by differentiating equation 4 with respect to me,
equating to zero and solving for me.
" A Nash equilibrium is defined as a situation in which each of two
sides chooses his best strategy, taking as given the optimal re­
sponse of the other side.
12This term is a slightly more general form of equation 3.

7

MAY 1986

FEDERAL RESERVE BANK OF ST. LOUIS

m aker cares about em p lo y m en t relative to inflation
preven tion at th e m argin.
As before, th e p o licy m ak er ch o o se s m, to m axim ize
th e so cial w elfare fu n ctio n in eq u atio n 5, taking m f as
given. Sin ce th e re is n o th in g th a t links th e p eriod s,
m axim ization o f eq u atio n 5 is equivalent to m axim iza­
tion o f w elfare w ith in e a c h period sep arately. M ore
form ally, th e p o licy m ak er m axim izes eq u atio n 6 for
all i:
(6) VV, = Aim* — mf) — —^

Table 3
Payoff Tables for a Typical Period in the
Dynamic Monetary Policy Game
I. Policymaker’s Payoff Table (from equation 6)
Policymaker
chooses (m,)

As before, th e p u b lic resists b ein g fooled . B e c a u se it
u n d e rstan d s th e stru ctu re o f in cen tiv es facin g th e p o l­
icym aker, it rationally sets mf = A in all p erio d s. Again,
th e eco n o m y en d s up w ith a positive rate o f inflation.
As before, th e d iscretio n ary so lu tio n is not optim al;
zero m o n ey grow th y ield s a value o f zero to th e p o licy ­
m ak er (if th e p u b lic ex p e cts m o n ey grow th to b e zero),
w h ile th e d iscretio n ary resu lt y ield s a so cial w elfare of
—A72.
ft is tem pting to argue th at a so p h isticate d policy­
m aker w ould elim in ate th is su bop tim ality by sim ply
co n sisten tly settin g m, = 0, th u s co n vin cin g th e pu blic
that mf shou ld equal zero as w ell. T h e pu blic, h ow ­
ever, know s that, as so o n as they ex p ect inflation to be
zero, the policym aker can in crease w elfare (to A72) by
reverting to th e d iscretio n ary inflation solu tion. B e­
ca u se th e policym aker will revert to d iscretio n in this
case, th e p u blic will rationally ex p ect that inflation will
equal A. As a result, th e b est solu tion, it^ = mf = 0 is
u nstable, w h ereas th e d iscretio n aiy (Nash) so lu tio n ni;
= m" = A is sta b le."

The Impact o f Asymmetric Information
T o th is p oint, th e p u blic an d th e p o licy m ak er w ere
a ssu m ed to have th e sam e inform ation. Su ppose,
how ever, th at th is is n o t th e case. B ack u s an d Driffill
(1985a, 1985b) c o n sid e r a m o d el in w h ich th e p o licy ­
m ak er is o n e o f tw o types: “w eak ” o r “stro n g .” If th e
p olicy m ak er is w eak, h is payoff m atrix is th e on e
sh ow n in table 2(1) or 3(f); he, th erefo re, h as an in c e n ­
tive to g en erate inflation. If th e p olicy m ak er is strong,
how ever, h e alw ays prefers zero inflation.

13lt is obtained from the first-order condition for the maximization of
( 6 ).
14The dynamic inconsistency of the first best solution was originally
noted by Kydland and Prescott (1977).

Digitized for
8 FRASER


0

0
A

As sh ow n in th e m o n eta iy p o licy m ak er’s pay-off m a­
trix in table 3, th e b est c h o ice is m, = A in all p e rio d s.13

Public expects (mf)

—3A2/2
A2/2

-A212

II. Public’s Payoff Table (from equation 4)
Policymaker
chooses (m,)

Public expects (mf)

0
A

-A 2
-A 2

In th e beginning, th e p u b lic assign s so m e p ro b a b il­
ity to th e co n d itio n th at th e p olicy m ak er is stron g and,
therefore, will n ot inflate. W eak p olicym akers are
tem p ted to inflate. However, sin ce th ey m axim ize
w elfare over several p erio d s, th ey have an in cen tiv e to
ap p ear strong, at least initially, to d isco u rag e in ­
flationary ex p ecta tio n s. T h e p u b lic w a tch es th e
a ctio n s o f th e p olicy m ak er an d ad ju sts its p robability
accord in g ly th at th e p o licy m ak er is strong. T h is p ro b ­
ability is co n sid ere d to b e a m easu re o f credibility.
As long as th e p o licy m ak er d o es n o t inflate, th e
p u b lic assign s so m e positive p robability to th e event
th at th e policym aker is strong, ff th e p olicy m ak er
inflates even o n e tim e, how ever, h e im m ed iately re ­
veals h im self to b e w eak. B e ca u se stron g p o licym akers
never inflate, th ere is n o w ay th at a p o licy m ak er ca n
reesta b lish h is lo st rep u tation . C on sequ en tly, o n ce
in flation starts, it co n tin u es forever.
Backus an d Driffill form ulate th is p ro b lem as a
dynam ic, m ixed -strategies B ayesian gam e u sin g K reps
an d W ilso n ’s (1982a, 1982b) n o tio n o f seq u en tia l eq u i­
librium .15 T h is form u lation ca p tu res th e in cen tive o f
th e w eak p olicy m ak er to a ct tem p o rarily as if h e w ere
stron g in o rd er to m ain tain future in flatio n aiy e x p e c ­
tatio n s at a low er level, ft also provides th e p u b lic w ith
a ratio n ale for w atch in g th e a ctio n s o f th e p o licy ­
m aker, at le a st u ntil it is know n th at h e is w eak. T h is
analysis is restricted , how ever, b y th e fact th a t th e p o l­
icym aker ca n b e o n e o f o n ly tw o u n ch a n g in g ty p es. As

,5A similar analysis appears in Barro (1985).

FEDERAL RESERVE BANK OF ST. LOUIS

a co n se q u e n ce , o n ce a rep u tation is destroyed, it
ca n n o t b e rebuilt. T h o se featu res o f th e an alysis are
in co n sisten t w ith th e observed freq u en t reversals in
th e rate o f m o n etaiy grow th in th e United States,
E ngland an d o th e r d em o cracies.

Criticism o f the Social Welfare
Approach
B eca u se eq u atio n 2, o r its m u lti-p eriod variant,
eq u atio n 5, is u sed frequ ently as a so cial w elfare
fu n ctio n in th e th eo retical literatu re on ce n tra l ban k
behavior, it is im p ortant to exam in e w hy it takes th is
sp ecific form .16T h e negative effect o f inflation o n social
w elfare resu lts from th e fam iliar lo ss o f co n su m e r
su rplu s th at inflation p ro d u ces th rou gh th e d ecrea se
in th e p u b lic’s real m o n ey b a la n ces. T h e positive
a sso ciatio n b etw een deviations o f em p lo y m en t from
its natu ral level an d social w elfare can be exp lain ed by
the ex iste n ce o f various lab o r m arket d isto rtion s (like
taxes an d u nem p loy m en t benefits) that m ake the
natural level o f em p loy m ent too low (Barro an d Gor­
don, 1983b). A n o th er exp lan ation , offered by C anzon eri (1985), is th at th e p re sen ce o f large u nion s
keeps real w ages too high and th e n atu ral em p lo y ­
m en t level too low.
T h e view th at th e ex iste n ce o f d isto rtio n aiy taxes
n ecessarily in d u ce s an inflationary bias on th e part of
a so cially m ind ed ce n tra l bank raises several q u e s­
tions. First, this n o tio n relies only on the d isto rtio n aiy
effect o f taxes on th e allo catio n o f tim e b etw een lab or
an d leisu re, n eg lectin g the utility from th e p u b lic good
that is fin an ced bv th e se taxes. Sin ce individuals take
th e level o f th e p u blic good provided by governm en t as
being in d ep en d en t from th e ir individual lab or-leisu re
d ecisio n s, w hile the cen tral bank takes into c o n sid e r­
ation th at th is level d ep en d s on total tax co lle ctio n s —
w h ich d ep en d in turn on total em p lo y m en t — th ere is
also an externality. If th e socially optim al level o f th e
p u blic good is h ig h er th an th e am o u n t that can be
fin an ced throu gh th e taxes co lle cte d in th e a b se n c e o f
cen tral bank in terven tion , th e bank h as an in cen tive to
in crea se total tax co lle ctio n s. W h eth er th is im plies
that it h as an incentive to in crea se em p loy m en t or
d ecrease it d ep en d s on th e tax stru ctu re and the
elasticity o f lab o r d em an d . In th e latte r case, th e tax
d isto rtion an d the p u blic good extern ality have c o n ­
flicting effects on th e so cially op tim al level o f emplo\'m ent in relation to its general eq u ilibriu m level in the
a b se n ce of cen tral bank in tervention . C ukierm an and
17For example, when there is too much of the public good in the no­
intervention equilibrium, the central bank has a deflationary bias,
provided labor demand is sufficiently elastic.




MAY 1986

D razen (1986) sh ow w ith in a n om in al co n tra cts fram e­
w ork o f the F isc h e r (1977) type that, if th e d em an d for
lab or is su fficiently in elastic, th e last effect d om in ates,
p ro d u cin g an in cen tiv e to d ecrea se em p lo y m en t via
u n a n ticip a ted deflation. F u rth erm o re, th e ran ge o f
ca ses in w h ich th e cen tra l bank tu rn s out n ot to have
an in flatio n aiy bias is by no m e a n s n egligible.17 T h e
u p sh o t is th at a so cially m in d ed p o licy m ak er facing
d isto rtio n a iy lab or taxes sh o u ld n ot be au to m atically
p resu m ed to p o ssess an in flatio n aiy bias.
Seco n d , if th e level o f em p lo y m en t is to o low b e­
cause; o f d isto rtio n a iy taxes, a full an alysis o f the
b eh avior o f policym akers sh o u ld be able to d eterm in e
sim u ltan eo u sly both in flation an d o th e r taxes, taking
into co n sid era tio n th e tax revenu es from inflation.
Su ch an ex ten sion is co n sid ere d by A lesina and Tabellini (1985) w ithin a fram ew ork in w h ich fiscal and
m o n eta iy p o licies are d eterm in ed by tw o in d e p e n ­
d en t au th o rities. An im p ortan t im p licatio n o f this
fram ew ork is th at th e resu ltin g eq uilibriu m rate of
inflation is n ot n ecessa rily su b op tim al. T h is will be
d iscu sse d m ore fully in the se c o n d in stallm en t o f this
survey.
Finally, th e so cial w elfare fu n ctio n in terp reta tio n o f
th e policy m ak er's o b jectiv es d o es n o t fit very w ell w ith
th e n o tio n th at th ere are tw o alternative types o f p o l­
icym akers. O ne possibility m ight b e th at th ere are tw o
alternative w elfare fu n ctio n s th a t ch a ra cte riz e th e
eco n om y. If th at is th e case, how ever, it seem s p e cu lia r
th at th e relevant on e is know n only to th e p o licy ­
m aker. In d eed , th is p o ssib ility see m s u n ten a b le. An­
o th e r p ossibility is that, w hile th e o b jectiv e fu n ctio n of
th e w eak p o licy m ak er is id e n tica l to th e so cia l w elfare
fu n ctio n , th e stron g p o licy m ak er’s o b jectiv e fu n ctio n
is different from it. O n ce it is reco g n ized th at the
ob jectives o f th e p o licy m ak er m ay differ from the
so cial w elfare fu n ctio n , how ever, th ere is n o rea so n to
re strict th e analysis to only a single alternative form u ­
lation . C o n sid eratio n o f a variety o f alternatives is
han d led by a political in terp reta tio n o f th e p o licy ­
m aker’s ob jective fu n ctio n .

THE POLITICAL APPROACH AS A
POSITIVE THEORY OF CEIVTRAL
BANK BEHAVIOR
R ecen t w ork in b o th e c o n o m ics an d p o litical sc i­
e n c e suggests th at m o n etary p o licy is n o t totally
divorced from th e g en eral p o litical p ro cess. F o r exam l6ln addition to the papers quoted above, those include Barro and
Gordon (1983a), Backus and Driffill (1983b), Rogoff (1985) and, to
some extent, Canzoneri (1985).

9

FEDERAL RESERVE BANK OF ST. LOUIS

pie, in sp ite o f th e F ed eral R eserve’s statu to ry in d e­
p e n d e n ce from o th e r b ra n c h e s o f g overnm ent, m o n e ­
tary p o licy is partly respon sive to th e d esires o f th e
P resid en t, C ongress, th e fin an cial co m m u n ity an d
p erio d ically so m e o th e r le ss visible in stitu tio n s or
gro u p s.18

,

Discretionary Policy Changing
Objectives and Asymmetric Information
T h e ce n tra l b an k know s b o th th e ex ten t o f th e
p o litical p re ssu re fo cu se d o n it to ch an g e m o n etary
po licy at any given m o m en t an d h o w likely it is to
a cco m m o d ate th is p ressu re. Fu rther, th e form ation of
effective co alitio n s d eterm in ed to ch a n g e th e co u rse
o f m o n etary p o licy is su b je ct to large sto c h a stic e le ­
m en ts. C ukierm an an d M eltzer (1986a) form alize th is
no tion w ith an o bjective fu n ctio n sim ilar to eq u atio n 5
in w h ich th e m onetary au th o rity ’s m arginal prefer-

18The precise channels through which these responses are elicited
are subtle and, at times, elude precise formulation because the
President, Congress and the Federal Reserve all have a common
interest in preserving an image of the Central Bank as an indepen­
dent, apolitical institution.
Kane (1980,1982) has argued that the Federal Reserve performs
a scapegoat function for the President and Congress. In return, the
Fed gets a fair degree of independence which is necessary in order
to credibly perform the scapegoat function. A general discussion of
the political approach in the context of monetary reform appears in
Willet and McArthur (1985).
Weintraub (1978, p. 356) concludes after summarizing the history
of the post-accord monetary policy that much of this policy “ . . . can
be explained just by noting who the President was when the policy
under review was in effect.” In a study of Presidential influence on
monetary policy, Beck (1982) concludes that presidential political
demands are somehow transmitted to the Fed. Beck notes that the
transmission mechanism requires further study but that it seems
clear that presidential preferences are an important determinant of
Fed policymaking (Beck, 1982, p. 443). Woolley (1984) holds a
similar view. Hetzel (1985) argues that current institutional arrange­
ments allow Congressmen to pass on political pressures of various
constituent groups to the Fed while avoiding association with the
consequences that adversely affect the welfare of other groups.
This explains Congress’ consistent preference (noted by Woolley,
1984, chapter 7) for attempting to influence monetary policy through
a variety of threats to limit the Fed’s institutional autonomy rather
than through an explicit mandate to guide monetary policy (Hetzel,
1985, p. 7). Since the autonomy of the Fed depends on Congress, it
must be at least somewhat sensitive to the wishes of Congress
provided the Fed values autonomy.
Both Congress and the Presidency are institutions largely con­
cerned with various redistributional considerations. As a conse­
quence the Fed is, possibly to a lesser degree, also sensitive to
redistributional considerations. In addition, the Fed is not indifferent
to the interests of groups with which it deals on a daily basis, e.g.,
banks and the financial community in general (Woolley, chapter 4).
Arthur Burns (1979) appears to share the view that the Fed is not a
totally free agent. He believes that the Fed can work to achieve price
stability only if the policy does not adversely affect production and
employment and does not irritate Congress. In Burns’ words, the
role of the Fed is to continue “ probing the limits of its freedom to
undernourish . . . inflation” (Burns 1979, p. 16).


10


MAY 1986

e n c e for e c o n o m ic stim u latio n vs. in flation p rev en tion
shifts ran d om ly th rou g h tim e. In th is form u lation , th e
co n sta n t m arginal rate o f su b stitu tio n A is re p la ced by
a ran d om variable x, w h ich reflects th e cu rre n t c o m ­
p ro m ise th at th e centred b a n k strikes b etw ee n advo­
ca tes o f e co n o m ic stim u latio n a n d ad vocates o f p rice
stability.'9
T h e cru cia l elem e n t in th is form u lation is that x, is in
a co n tin u o u s state o f flux an d is n o t know n by th e
gen eral pu blic. However, th e p u b lic ca n ration ally an d
gradually d e te c t ch a n ges in x, by observing ch a n g es in
th e rate o f grow th o f th e m o n ey su pply; th is d etectio n
activity provides an ex p la n a tio n for “Fed w a tch in g .”
Sin ce th e p u b lic is u naw are, at an y given m o m en t, o f
th e p re cise value o f th e ce n tra l b a n k ’s cu rre n t x„ th e
cen tral b an k is able to affect o u tp u t th rou g h su rp rise
m on ey creatio n .
T h e re are b o th sim ilarities an d d ifferen ces b etw een
th e so cial w elfare a n d th e p o litical in terp reta tio n o f
th e p olicym aker's o b jectiv e fu n ctio n ad o p ted in th is
sectio n .20 T h e p o litical a p p ro a ch view s th e p o licy ­
m aker as ch o o sin g m o n ey grow th to m axim ize th e
ex p e cted value o f
00

(7) i l 0 Pi[X‘ (mi "

m2

----- J - h

w h ere x, is a sto c h a stic variable w ith so m e p e rs ist­
en ce.2’
E qu atio n 7 is form ally equivalent to eq u atio n 5 w ith
th e sole ex cep tio n th at A is re p la ced by x,; how ever, its
in terp reta tio n is qu ite different. E q u atio n 7 re flects th e
cu rren t p o litical co m p ro m ise b etw ee n co m p etin g o b ­
jectiv es preferred by th e policy m ak er; it is n o t a so cial
w elfare fu n ctio n . Sim ilarly, th e d isco u n t fa cto r p
reflects th e tim e p referen ce o f th e p o licy m ak er as an

19The motivation of either group of advocates may be mostly distribu­
tional. Some people are relatively more adversely affected by
unemployment than by inflation. Changes in x, reflect changes in (a)
the relative sizes of those groups, (b) the degree to which they are
adversely affected by inflation and unemployment and, (c) the
perceptions of the central bank about those changes and the degree
of urgency in accommodating them. In some long-run sense, the
central bank may be responding to the desires of voters. However,
the public does not know the extent to which the central bank
currently responds to voters.
“ The following discussion draws heavily on Cukierman and Meltzer
(1986a).
21The precise stochastic structure is:
(a) x, = A + p
A> 0
(b) p = pp,_, + v,

0<p< 1

(c) v, ~ N (0, of).
A is a positive, publicly known, constant and p, a first-order Markoff
process whose realization is known only to the policymaker.

MAY 1986

FEDERAL RESERVE BANK OF ST. LOUIS

in stitu tio n w ith its ow n p riorities ra th er th an the
social rate o f d isco u n t.23
T h e political in terp retatio n avoids som e o f th e criti­
cism s d irected tow ard th e so cial w elfare in terp reta ­
tion for th e p o licy m ak er’s o bjective fu n ctio n . Thu s,
w hile it is difficult to explain w hy th e m o n eta iy
au th ority sh o u ld b e b e tte r in fo rm ed abo u t th e so cial
w elfare fu n ctio n th a n th e pu blic, it is easy to believe
th at th e policym aker is b e tte r inform ed ab o u t x„
w h ich sim ply reflects th e p o licy m ak er’s cu rren tly p re­
ferred co m p ro m ise b etw ee n co n flictin g o b jectiv es.23
T h e p olicy m ak er a cts in a d iscretio n ary m a n n e r in
p lan n in g th e rate o f m o n ey grow th (and inflation),
taking into a cc o u n t th e tradeoffs h e faces betw een
cu rren t stim u latio n an d th e p u b lic ’s fu tu re in ­
flationary ex p ectatio n s. In p articular, th e p olicy m ak er
know s th at cu rre n t a ctio n s w h ich raise future in ­
flation ex p e ctatio n s m ake it m o re co stly (in term s o f
inflation) to fu rth er stim u late th e eco n o m y in th e
future. T h e policym aker ch o o se s b o th th e cu rren t
m o n ey grow th an d p lan s for fu tu re m o n ey grow th to
achieve a m axim u m for th e ex p e cted value o f th e
objective fu n ctio n in eq u atio n 7.

The Effects o f Imperfect Control and
Uncertain Future Objectives
T h e d ecisio n p attern ju s t d escrib ed is co m p lica ted
by tw o ad d itional co n d itio n s. First, th e p olicy m ak er is
assu m ed to have im p erfect co n tro l o f th e m o n ey
su p p ly — a ctu a l m o n ey grow th deviates rand om ly
from th e grow th p la n n ed by th e m o n etary au th o rity as
sh o w n in eq u atio n 8,

(8) m, = mf + Tjj,
w h ere m f is th e rate o f m o n e ta iy grow th p lan n ed by
th e p o licy m ak er for period i and
is period i’s
realizatio n o f a w h ite n o ise p ro cess, th e v arian ce of
w h ich is d eterm in ed by th e p re cisio n o f existin g
m o n etary co n tro l p ro ced u res.24

“ This formulation is consistent with the views of long-time students of
the Fed like Lombra and Moran (1980), Lombra (1984) and Kane
(1982) concerning the Federal Reserve System. In particular, Kane
(1982, p. 207) writes:
“ Inherent in the utopian view of the Fed is the presumption that the Fed
can somehow evaluate the public interest on its own. In the contempo­
rary United States, it is hard to conceive of the public interest except as
a delicate balance of conflicting private interests.”

23In addition, the political approach does not rely on the notion that
distortionary taxes necessarily induce policies biased toward infla­
tion.
24The case in which the level of precision in monetary control is a
choice variable is considered later in this paper.




Secon d , th e p o licy m ak er is a ssu m ed to b e u n certa in
abou t h is ow n future o b jectiv es. He know s, how ever,
th e ir cu rre n t values an d u se s th e ir p e rsisten t s tru c ­
tu re (see foo tn ote 21) to derive op tim al p re d icto rs o f
future values o f x,. T h e se p re d ictio n s are n ecessary ,
even th ou gh n o co m m itm e n t to any p a rticu la r future
m o n ey grow th is required , b ec a u se h e know s th at th e
cu rre n t rate o f m o n eta ry grow th w ill affect future
in flatio n aiy e x p e cta tio n s. If h e e x p e cts to ca re m o re
ab o u t em p lo y m en t in th e future th a n h e d o es now , h e
will in cre a se h is ability to crea te su rp rises at relatively
low in flation in fu tu re p erio d s b y c h o o sin g a relatively
low cu rren t m o n e ta iy grow th. If h e e x p e cts to ca re le ss
ab o u t em p lo y m en t in th e fu tu re th a n h e d o es at
p resen t, h e will ch o o se faster cu rren t m o n eta iy
grow th (and faster inflation).
T h e im p o rtan t p o in t is th at th e p o licy m ak er m u st
p re d ict h is ow n u n c e rta in o b jectiv es in th e future
w h en ch o o sin g th e cu rre n t rate o f m o n ey grow th. T his
u n certa in ty arises b e c a u se h e d o es n o t cu rren tly
know for ce rta in w h at th e fu tu re op tim al (for him)
b a la n ce w ill b e b etw een p re ssu res ex erted b y various
grou p s an d in stitu tio n s. T h e m o re stable th e u n d erly ­
ing so cio -p o litical en viron m en t, th e sm a ller th is u n ­
certa in ty w ill b e. T h e u n certa in ty ca n b e m ea su red by
th e varian ce o f th e p o licy m ak er’s o b jectiv es; th is is
d en o ted as ct2 (see fo o tn o te 21).
C ukierm an an d M eltzer (1986a) (CM hereafter) show
th at th e so lu tio n to th e p o licy m ak er’s d ecisio n p ro b ­
lem in eq u atio n 7 is
(9) mr = B„ A + B p.,
w h ere B„ an d B are positive co n sta n ts th at d ep en d on
th e p aram eters o f th e p o licy m ak er’s o b jectiv e fu n ctio n
an d th e p re cisio n o f m o n etary co n tro l, a n d w h ere p, is
th e ran d o m p art o f x, (see fo o tn o te 21). W h en eq u atio n
9 is su b stitu ted in to eq u atio n 8, actu al m o n ey grow th
ca n b e ex p ressed as
(10) m, = B„ A + Bp, +

tv

T h is m od el a ssu m es that th e p u b lic d o es n o t know
the cu rren t sta te o f th e p o licy m ak er’s o b jectiv es — x(
o r p, is know n only by th e p o l i c y m a k e r '.11 T h e pu blic,
how ever, know s th e p o licy m ak er’s d e cisio n ru le in
eq u atio n 10 an d h a s observed m in e a c h p erio d up to
an d in clu d in g th e previous o n e. Sin ce
h as som e
degree o f p ersisten ce, past values o f m o n ey grow th
convey noisy, b u t m eaningfu l, in fo rm atio n ab o u t fu ­
tu re m o n ey grow th to th e p u b lic. T h e n o ise is in d u ce d
by th e co n tro l error, t],.
25Since A is public information, knowledge of x, is equivalent to
knowledge of p,.

11

FEDERAL RESERVE BANK OF ST. LOUIS

T h e op tim al p re d icto r o f fu tu re m o n ey grow th ad ­
ju s ts slow ly to actu al ch an g es in observed m o n ey
grow th; specifically,
(11) mf = (p —X) m ,., + Xm;_, + (1 —p) B(>A.1*
T h e p a ra m e te r X. is d eterm in ed by th e d egree o f
p e rsiste n c e in th e p o licy m ak er’s objectives, th e p re c i­
sion o f m o n etary co n tro l an d th e degree o f instability
in th e political en viro n m en t o f th e p o licy m ak er as
m ea su red by ctJ. B e c a u se X is b o u n d e d b etw ee n 0 an d
p, th e value o f p —X is positive.
E qu atio n 11 sp ecifies th at ex p e cted m o n ey grow th
is a w eighted average o f last p e rio d ’s m o n ey grow th,
n v ,, th e last p erio d ’s ex p ectatio n , m'_, an d B„ A.27
Inflationary ex p ectatio n s p artially a d ju st to ch an g es
in a ctu al an d p lan n ed m o n ey grow th b eca u se , as
im plied by eq u atio n 10, actu al m o n ey grow th is in ­
flu en ced bo th by p e rsisten t ch an g es in th e objectives
o f th e p olicy m ak er an d b y tran sitory co n tro l errors.
T h e p u blic, therefore, rationally attrib u tes only p art of
th e flu ctu atio n s in m to p e rsisten t ch an g es in th e
o b jectives o f th e policym aker.
W hen ch o o sin g th e rate o f m o n ey grow th, th e p o l­
icym aker takes in to co n sid era tio n its effect o n future
inflation ex p e ctatio n s (equ ation 11). In fact, th e p o licy ­
m ak er’s d ecisio n rule (equation 9) is th e so lu tio n to
m axim ization o f th e ex p e cted value o f his o bjectiv e
fu n ctio n (equation 7), given h o w th e p u b lic’s inflation
ex p ectatio n s are form ed (equation 11).
T h e equilibriu m form ed from th e se eq u atio n s is
self-fulfilling. Given th e d ecisio n rule o f th e p o licy ­
m aker (equation 9) an d th e m o n ey grow th eq u atio n
(equation 10), th e b est p re d icto r o f fu tu re inflation is
given by eq u atio n 11. Conversely, given th is pred icto r,
th e b est strategy for th e policym aker is show n by
eq u atio n 9, w h ich in d u ce s th e m o n ey grow th show n
by eq u atio n 10.

Monetary Surprises and Credibility
T h e self-fulfilling n atu re o f eq u ilibriu m d o es n o t
m ean th a t th e re are n o m o n etary su rp rises. In fact,
m o n etary su rp rises o c c u r frequ ently; th e ir ex p e cted
value, how ever, is zero. T h e reaso n for frequ ent m o n e­
tary su rp rises is th at th e objectives o f th e p olicy m ak er

MAY 1986

are co n tin u ally ch an g in g ; th e pu b lic, how ever, b e ­
co m e s aw are o f th o se ch a n g es only gradually by
observing p a st rates o f in flation. T h u s, w h en th e p o l­
icym aker b e co m e s relatively less co n c e rn e d about
inflation prevention, th e p u b lic reco g n izes th is p o licy
ch an g e o n ly gradually. In th e in terim , a ctu a l in flation
is h ig h er th a n ex p e cted a n d em p lo y m en t is above its
n atu ral level. Conversely, w h en th e p o licy m ak er b e ­
co m es relatively m o re co n c e rn e d abou t in flation p re ­
vention, inflation is lo w er th a n ex p e cted an d o u tp u t is
b elo w its n atu ral level u n til th e p u b lic reco g n iz es th is
p o licy ch an g e.
T h e p u blic m o n ito rs ch a n g es in m o n etary grow th
b ec a u se th e se figures provide ad d itio n al in form ation
abou t future inflation. T h is in cen tiv e to m o n ito r
m o n ey grow th exp lain s w h y re so u rc e s are devoted to
Fed w atch in g (Bull, 1982; Hardouvelis, 1984). In th e
ab se n ce o f asy m m etric inform ation, th ere w ould b e
no reason for th is activity.
R ecen tly F is c h e r (1984) h as stresse d th e im p o rta n ce
of th e sp eed w ith w h ich th e p u b lic’s ex p e cta tio n s
ad ju st for d eterm in in g th e co sts o f d isin flation p o licy
actio n s. T h e fa ster ex p e cta tio n s a d ju st, th e lo w er th e
ou tp u t co sts o f d isin flation w ill be. CM sh o w th a t th e
sp eed w ith w h ich ex p e cta tio n s a d ju st is sy stem ati­
cally related to th e p re cisio n o f m o n etary co n tro l. In
particular, th e less p re cise m o n etary co n tro l is, th e
larger is X in eq u atio n 11 an d th e lo n g er it takes fo r th e
pu b lic to reco gn ize th a t th e p o licy m ak er’s o b jectiv es
have ch an g ed .28
CM co n ceiv e o f cred ib ility as th e sp eed w ith w h ich
th e p u b lic reco g n izes th a t a ch a n g e in th e p o licy ­
m aker's ob jectiv es h a s actu ally o ccu rred . T h is c o n ­
ce p t o f cred ibility seem s a p p rop riate w h en p o licy is
d is c r e tio n a iy a n d th e p o lic y m a k e r’s o b je ctiv e s
(know n o n ly to him ) are in c o n sta n t flux. T h e p a ra m e­
te r X from eq u atio n 11 is a n atu ral an d co n v en ien t
m easu re o f cred ibility.23 U sing th is m easu re, cred ib ility
is higher, th e m o re p re cise m o n etary co n tro l is (the
low er th e varian ce o f T)).
It h as b e e n observ ed th a t sh o rt-ru n co n sid era tio n s
often are given relatively large w eight in th e actu al
co n d u ct o f m o n etary p olicy.30 In term s o f th e fra m e­

28With a higher X, less weight is given to the last observed inflation,
m,.,, and more weight is given to the last inflation expectation, mp_,.
26ln statistical terms mf is the expected value of m, conditioned on
nrij_1f mj_2> •. •

29As shown in equation (1 Ob) of CM, \ is a known function of <r2 and p
as well so that credibility is also influenced by the instability of
objectives and their persistence.

27Taking unconditional expected values on both sides of equation 10,
B0 A can be recognized as the unconditional mean money growth.

“ For example, see Brunner and Meltzer (1964), Kane (1977, 1980),
Pierce (1980), and Mayer (1982).

Digitized 12
for FRASER


FEDERAL RESERVE BANK OF ST. LOUIS

w ork p re se n te d h ere, th is observ ation m e an s th at th e
p olicy m ak er h as a high tim e p re fe ren ce ((3 in eq u atio n
7 is low). CM sh o w th a t th e h ig h er th e p o licy m ak er’s
tim e p referen ce, ce te ris p aribus, th e h ig h er th e varia­
bility and th e u n certain ty in th e rate o f m o n etary
grow th.
T h e ch a racte rizatio n o f cred ibility differs so m ew h at
am on g various m od els o f m o n etary p o licy behavior. As
ex p lain ed above, in th e CM form ulation, cred ibility is a
param eter. It m e asu res th e sp e ed w ith w h ich th e
p u b lic d e tects th e actu al ch an g es in th e p olicym aker's
ob jectives. CM ch a ra cte riz e cred ibility u n d e r d isc re ­
tio n an d asy m m etric inform ation . In m o d els w ith tw o
types o f p olicym akers, cred ibility o r rep u tatio n is a
state variable.31 It is th e cu rre n t su b jectiv e probability
assign ed by th e p u b lic to th e event th a t th e p o licy ­
m aker is strong.
B arro an d G ordon (1983b), on th e o th e r hand , focu s
on th e cred ibility o f th e first-best, n o n -in flatio n ary
p o licy an d p o in t out th at th is p o licy is “in c re d ib le ”
u n d e r d iscretio n an d sy m m etric in form ation .

The Credibility o f Publicly Announced
Monetary Targets
C ukierm an an d M eltzer (1986b) ex ten d th e p o liti­
cally based m od el to th e ca se in w h ich th e p o licy ­
m ak er m ak es n o isy (e.g., a n n o u n cem e n ts o f target
ranges ra th er th a n a sp ecific level) but u n b iased a n ­
n o u n c e m e n ts abou t h is fu tu re p lan s.32 In th is case, the
p u b lic find s it op tim al to u se th e in fo rm atio n from
p a st a n n o u n c e m e n ts in ad d ition to p ast m o n etary
grow th to form its e x p e ctatio n s. In co m p a riso n to th e
ca se in w h ich n o a n n o u n c e m e n ts are m ad e, n oisy
a n n o u n c e m e n ts n ev er in cre a se (and u su ally d ecrease)
th e p u b lic’s u n certain ty abou t fu tu re m o n etary
grow th. In th e ca se in w h ich a n n o u n c e m e n ts are
m ade, cred ibility is natu rally d efined as th e deviation
b etw een th e cu rre n t a n n o u n c e m e n t an d the p u b lic’s
ex p ectatio n . T h is deviation d ep en d s on th e relative
am o u n ts o f n o ise in b o th th e co n tro l o f th e m o n ey
supply an d th e a n n o u n cem e n ts, as w ell as on the

31Backus and Driffill (1985a, 1985b); Barro (1985).
32House Concurrent Resolution 133, and later the HumphreyHawkins Act, require the Federal Reserve to announce planned
rates of growth for principal monetary aggregates. The purpose of
this legislation is to provide the public and Congress with more
precise information about the particular monetary actions contem­
plated by the monetary authority. Announcements are (or have
been) made in Germany, Japan, U.K., France, Canada, Australia
and Switzerland.




MAY 1986

m ag n itu d e o f re ce n t ch a n g es in th e p o licy m ak er's
o bjectiv es.

THE ROLE OF AMBIGUITY AND
SECRECY IN THE CONDUCT OF
MONETARY POLICY
Various stu d en ts o f ce n tra l ban k b eh av ior have
su ggested th at th e low cred ib ility a n d am biguity in th e
sp ecifica tio n o f o b jectiv es by ce n tra l ban k s m ay b e, to
so m e exten t, d elib erate.33 T h e p o litical a p p ro a ch p re ­
sen ted in th e previous se c tio n provides an ex p la n a ­
tion for th is in clin a tio n for p o licy am biguity. C on sid er
th e ca s e in w h ic h th e level o f n o ise in m o n etary
co n tro l is a c h o ice variable ra th er th an a tech n o lo g ica l
d atum . T h e p o licy m ak er w ill ch o o se, o n c e a n d fo r all,
th e varian ce o f th e m o n etary co n tro l erro r th a t m ax i­
m izes th e u n co n d itio n a l e x p e cte d value o f h is o b je c ­
tive fu n ctio n , w h ich , for th is d iscu ssio n , is eq u a tio n 7.34
F o r any given level o f co n tro l p recisio n , th e p lan n ed
an d actu al m on ey grow th are d eterm in ed by eq u a ­
tio n s 9 an d 10, respectively, an d th e p u b lic ’s in ­
flationary ex p e cta tio n s are d eterm in ed by eq u atio n
11. By ch o o sin g m ore n oisy co n tro l p ro ced u res, the
policym aker in cre a s e s \ in eq u atio n 11; this, in turn,
in crea ses th e len gth o f tim e it takes th e p u b lic to
reco gn ize a ch an g e in th e p o licy m ak er’s objectiv es.
W h eth er a lo n g er reco g n itio n p erio d is desirable,
how ever, d ep en d s u p o n th e ch a n g e in p olicy m ak er
o bjectives. It is advantageous w h en th e policym aker
b e co m e s relatively m o re co n c e rn e d ab o u t ec o n o m ic
stim u lation ; in th is case, h e ca n p ro d u ce positive
su rp rises for a lo n g er tim e p eriod . W h en th e p o licy ­
m aker b e co m e s relatively m o re c o n c e rn e d ab o u t in ­
flation, how ever, a h ig h er \ is d etrim en tal; it len g th en s
th e period o f re cessio n an d negative su rp rises n e c e s ­
sary to d ecrea se inflation. T h u s, the policym aker
w ould like to have lo w er cred ib ility (in th e CM sense)

'“ In recent hearings before the Joint Economic Committee, Lombra
argues that the observed incompleteness in the specification of
quantitative goals for monetary policy is deliberate (Lombra, 1984 p.
113). Similar views are expressed in Brunner and Meltzer (1964) and
Lombra and Moran (1980). The penchant of the Central Bank for
secrecy has recently been revealed in the legal record of a case in
which the Federal Open Market Committee (FOMC) was sued under
the Freedom of Information Act of 1966. The suit required the FOMC
to make public immediately after each FOMC meeting the policy
directives and minutes for that meeting (Goodfriend, 1986). The
Federal Reserve argued the case for secrecy on a number of different
grounds. The important issue from the point of view of this section is
that the Federal Reserve attempted to preserve its information
advantage.
“ The following discussion is based on section VI of Cukierman and
Meltzer (1986a).

13

FEDERAL RESERVE BANK OF ST. LOUIS

w h en h e b eco m es m ore in tere ste d in stim u latin g
em p lo y m en t an d h ig h er cred ibility w h en h e b e c o m e s
m o re in terested in preven tin g inflation.35
A lthough positive an d negative su rp rises ca n c e l
e a c h o th e r ou t o n average, th e p o licy m ak er m ay still
find it advantageous to ch o o se co n tro l p ro ced u res
th at slow dow n p u b lic reco g n itio n o f ch an g es in his
objectives. G reater am biguity provides th e p o licy ­
m aker w ith g reater co n tro l in tim ing m o n eta iy su r­
p rises. W h en th e re is m o re am biguity ab o u t policy, h e
ca n create larger positive su rp rises w h en h e ca res
m ore about stim u latio n an d leave th e inevitable n eg a­
tive su rp rises for p erio d s in w h ich h e is relatively m ore
co n c e rn e d abou t inflation.
T h u s th e p olicy m ak er m akes a o n ce-an d -fo r-all (po­
litically) op tim al c h o ic e o f co n tro l p ro ced u res th at
also d eterm in es h is p u b lic cred ibility. T h is c h o ice is
sy stem atically related to th e degree o f tim e p re fe ren ce
o f th e policym aker; in particu lar, p o licy m ak ers w ith a
stro n g er tim e p re fe ren ce w ill c h o o se le ss p re cise c o n ­
trol p ro ced u res.36
M oreover, th e h ig h er th e d egree o f u n certain ty in
th e p o licy m ak er’s objectives, th e m o re likely h e is to
ch o o se le ss p re cise co n tro l p ro ced u res an d lo w er
credibility. W hen th e p o licy m ak er’s o b jectiv es are re l­
atively u n stab le, a rational p u b lic w ill give m ore w eight
to re ce n t d evelop m ents in forecastin g th e future rate
o f grow th o f m oney. C onsequen tly, for a given p re ci­
sio n in m o n eta iy co n tro l, it is m o re difficult to exploit
th e b en efits o f m o n etary su rp rises. By d ecreasin g th e
p re cisio n o f m o n eta iy co n tro l, a p o licy m ak er w ith
relatively u n stab le o bjectiv es c a n p artially offset th is
effect by in creasin g th e len g th o f tim e it takes th e
p u b lic to d etect a given shift in its objectives.

ESTABLISHING CREDIBILITY BY
DETERRENCE

MAY 1986

in a p riso n e rs’ d ilem m a resu ltin g in excessiv e in ­
flation, it h a s b e c o m e n atu ral to look for m e ch a n ism s
th at w ou ld elim in ate o r re d u ce th is in efficien t resu lt.
Obviously, a first-b est so lu tio n w ould b e to effectively
co m m it th e p olicy m ak er to a zero in flation policy.37 If
s u ch co m m itm e n ts are im p o ssib le, se c o n d -b e st so lu ­
tion s m ay b e sought.
One seco n d -b e st so lu tio n th at relies o n d e terre n ce
w ithin a sy m m etric in form ation en v iro n m en t has
b ee n su ggested in B arro an d G ordon (1983a). It ca n b e
illu strated u sin g th e re la tio n sh ip s previously d e ­
scrib ed . T h e b a sic id ea is th at th e p u b lic m u st d e te r­
m in e its in flation ex p e cta tio n in a w ay th at d eters th e
p o licy m ak er from ch o o sin g its o p tim al d isc re tio n a iy
rate o f inflation, fo r exam p le, A in eq u a tio n 6. Su p p o se
th a t th e p o licy m ak er a n n o u n c e s a rate o f in flation , m *,
th at is low er th a n A. T h e p u b lic th e n sets its in ­
flationary ex p e cta tio n for th e cu rre n t p erio d as fol­
low s: If a ctu al in flation in th e previou s p erio d a cco rd s
w ith e x p e cta tio n s, th ey e x p e ct th a t in flatio n w ill c o n ­
tin u e at m *. If th e previou s p e rio d ’s in flatio n d o es n o t
acco rd w ith e x p e cta tio n s, th ey e x p e ct in stea d th at th e
m o n eta iy a u th o rity w ill inflate at th e h ig h er d isc re ­
tionary rate, A. T h u s, w h en ev er th e m o n e ta iy a u th o r­
ity in flates at rate A ra th e r th a n a t its a n n o u n c e d rate
m*, th e p u b lic “p u n is h e s ” it fo r o n e p e rio d by believ­
ing th at it w ill co n tin u e to do so in th e n ex t p eriod as
w ell.3*
T h e m o n e ta iy au th o rity m axim izes its o b jectiv e
fu n ctio n (equ ation 5) s u b je c t to th e p u b lic's behavior.39
In co n sid erin g w h e th e r to in flate at rate A today, it
co m p a res th e d ifferen ce b etw ee n th e cu rre n t value o f
so cia l w elfare w h en it in flates at rate A ra th e r th a n at
rate m * (given th a t th e p u b lic e x p e cts m*) w ith th e
d isco u n ted value o f th e lo ss in n ex t p e rio d ’s w elfare
b ec a u se th e p u b lic’s in flation ex p e cta tio n s in crea se
from m * to A.“ As lon g as th e la tte r term (w hich a cts as
a d eterrent) is larger th a n th e fo rm er te rm (w hich

Ever sin c e K ydland an d P resco tt (1977) p o in ted out
th at th e m o n eta iy au th ority an d th e p u b lic are cau g ht
370 r to whatever the optimal rate of inflation happens to be.
35This may explain why public concern about lack of credibility is
aroused mostly when disinflation is considered. Not much concern
was expressed at the end of the '60s and the ’70s complaining about
the lack of credibility of the increased inflationary policies of those
times.
^Long-time students of the Fed like Brunner and Meltzer (1964),
Kane (1977, 1980), Mayer (1982) and Pierce (1980) suggest that
the Federal Reserve engages primarily in "fire fighting.” In terms of
the model, this would imply a high rate of time preference (low (J in
equation 7). In conjunction with the result obtained by CM, this
implies that the Fed is likely to have a preference for incomplete
control procedures and imperfect credibility.

Digitized for
14FRASER


“ In spite of its popularity, this term does not quite catch the function of
this strategy. The idea is not to punish the monetary authority but
rather to deter it from inflating at the discretionary rate A. This
observation is due to Edward Green.
39The example here is within the social welfare framework in which the
policymaker’s objectives are identical to the social welfare function.
•“ The calculation of this loss is based on the understanding that the
monetary authority chooses A also in the next period. The reason is
that this choice yields a better value to its objective function than the
choice m*. Given that, in the next period, expectations are at A,
inflation at A yields - A2/2 to the policymaker whereas inflating at m*
yields A(m* - A) - (m*)2/2 which is smaller for any m *<A.

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1986

re p rese n ts th e tem p tatio n to inflate at rate A), th e p o l­
icym aker p ick s m *, th e lo w er inflatio n rate.
Form ally (from eq u atio n 5), th e co n d itio n for effec­
tive d ete rre n ce o f th e h ig h er inflation A is
ft

(m *l2 — A2

(12) -f- [(A2 - Im ? ] > A (A - m*) + ----- ---------

T h e left-h an d term is th e d isco u n ted value o f th e loss
in n ex t p e rio d ’s w elfare d ue to th e in crea se in e x p e cta ­
tio n s. T h e rig h t-h an d term is th e gain in cu rren t
w elfare in d u ce d by h ig h er cu rre n t em p lo y m en t.4'
T h e lo w est cred ibly su stain ab le rate o f inflation ca n
b e fo u n d b y eq u atin g th e tw o sid es o f eq u atio n 12 an d
solving for m *.42 T h e so lu tio n is show n in eq u atio n 13:

T h is rate is h ig h er th a n th e first-b est zero in flation, b u t
lo w er th a n th e rate o f inflation, A, th a t w ould o c c u r in
th e a b se n ce o f d eterre n ce . E qu atio n 13 ex p resses the
b est en fo rceab le ru le as a fu n ctio n o f th e d isco u n t
fa cto r p. T h e h ig h er th e d egree o f tim e p referen ce, th e
h ig h er th e m inim u m su stain ab le rate o f inflation will
b e.43 O n ce th is m e ch a n ism is in p lace, it is selffulfilling: th e p u b lic believes th at th e p olicy m ak er will
inflate at rate m* and, ind eed , th e p o licy m ak er d o es so.
In th e a b se n c e o f co m m itm en ts, th erefo re, a seco n d b est lo w er rate o f inflation can be cred ibly su stain ed
by an ap p rop riate d eterre n ce m ech an ism .

Criticism o f the Deterrence Approach to
Central Bank Credibility
T h e d ete rre n ce ap p ro a ch to e n h a n cin g ce n tra l ban k
cred ib ility h as b e e n in terp reted by so m e (e.g., Barro
a n d G ordon, 1983a) as a positive th eo ry o f in flation.44
T aylor (1983), how ever, raises d o u bts abou t its u sefu l­
n ess as a positive th eo ry o f inflation o n th e g rou n d s

■"Note that the ideal inflation expectation, m* = 0, cannot be
sustained if there is positive time preference. It would require the
inequality

to hold; however, this condition cannot be satisfied when (5 < 1. A
somewhat higher rate of inflation can be sustained by this mecha­
nism even for (5 < 1.
42Since this is a quadratic equation there are two roots, the smallest of
which corresponds to the minimum credibly sustainable inflation.

that, in o th e r sim ilar d yn am ic in c o n siste n cy situ a ­
tion s, so ciety h a s fou n d w ays to circu m v en t th e p ro b ­
lem . He cite s p a ten ts as a device for elim in atin g th e
d yn am ic in co n sisten cy problem s faced by inventors
as an exam ple.
In addition, th e d eterre n ce equilibriu m im plies that
th e rate o f inflation rem ain s co n sta n t (Canzoneri,
1985). T h is im p licatio n is clearly at od d s w ith observa­
tion s th at b o th inflation an d m o n etary grow th flu c­
tu ate su b stan tially over tim e. F u rth er, th e d eterre n ce
equilibriu m d ep en d s critically on th e p u n ish m en t
strategy a ssu m ed in th e analysis. C on sequ en tly, th e
in finite-h o rizo n m o n etary p o licy gam e h a s m u ltip le
Nash equilibria w ith n o m e ch a n ism for ch o o sin g
am ong th em (Backus an d Driffill, 1985a). Th erefore,
an y sp ecific link b etw een th e cu rren t a ctio n s o f th e
p olicym aker an d th e future ex p e cta tio n s o f th e pu blic
is strictly arbitrary.
Finally th e d eterre n ce strategy m ay b e su b je ct to a
free rid er problem .45 Individuals m ay sim ply find that
it is n o t w orth w h ile to ach ieve a lo w er rate o f inflation
via th e d eterre n ce m e ch a n ism if th e private co sts o f
m on itorin g th e p o licy m ak er’s a ctio n s are h ig h er th an
th e m arginal private b en efits. T h is problem , w h ile o f
le sser im p o rtan ce in th e co n tex t o f oligopoly theory
from w h ich th e form al stru ctu re o f th e d eterre n ce
equilibriu m above h a s originated, m ay b e serio u s if th e
p u b lic is co m p o sed o f m any individuals.46 E ach in d i­
vidual m ay rely o n th e o th ers to d eter th e policym aker
from actin g in a d iscretio n ary m an n er, th u s elim in at­
ing th e d eterre n ce m e ch a n ism th at m ad e th e low er
inflation p o licy cred ib le in th e first p lace.

CONCLUDING REMARKS
Trad ition al e co n o m ic analysis gen erally h a s treated
p o licy m ak ers’ b eh av ior as d eterm in ed exogen ously. In
co n trast, re ce n t literatu re o n cen tra l ban k b eh avior
focu ses explicitly on how th e m otives, co n stra in ts and
in form ation o f policy m ak ers an d th e p u b lic d eterm in e
m on etary policy o u tco m es.
Som e an alysts u se a p o litical exp lan atio n o f th e p o l­
icym aker’s ob jectiv es; o th ers id entify th e p o licy ­
m ak er’s objectives w ith a social w elfare fu n ctio n . B oth
ap p ro a ch es sh ow h o w an in flation ary b ias is crea ted
by in tera ctio n s b etw een th e p olicy m ak er an d th e

“ Obviously other deterrence mechanisms will yield different sustain­
able ranges for the rate of inflation.
44lt also can be considered from a normative point of view, in which it
represents a mechanism that improves welfare in comparison to a
situation in which this mechanism is absent.




“ Suggested by Edward Green in conversation.
“ J. Friedman (1971, 1977) contains an early discussion of the
deterrence strategy in the context of oligopoly.

15

FEDERAL RESERVE BANK OF ST. LOUIS

p u b lic. M odels utilizing th e p o litical ap p ro ach , h ow ­
ever, see m to b e b e tte r able to exp lain tw o w idely
observed p h en o m en a: th e p referen ce o f m onetary
a u th o rities fo r am biguity in p u b lic p o licy p ro n o u n c e ­
m en ts an d th e large sw ings in actu al rates o f m o n ey
grow th and inflation. U nfortunately, existin g p o litical
m o d els have n o t id entified explicitly ho w various
g roups an d p o litical in stitu tio n s co m b in e to sh ap e th e
o b jectives o f th e m o n e ta iy au thority.47
M ore recently, m o d els have ap p eared th at co m b in e
explicitly som e in tera ctio n b etw een p o litical behavior,
in stitu tio n s, an d e c o n o m ic policym aking. Som e o f
th e se m o d els rely on th e e x iste n ce o f lo n g -term c o n ­
tracts to in d u ce a trad eoff b etw een low er inflation and
stim u lation . A ce n tra l th e m e o f th is literatu re is th e
o ptim al d esign o f m o n etary in stitu tio n s. T h o se devel­
o p m en ts w ill b e d escrib ed in th e se c o n d p art o f th is
survey.

MAY 1986
Canzoneri, Matthew B. “ Monetary Policy Games and the Role of
Private Information,” American Economic Review (December
1985), pp. 1056-70.
Cukierman, Alex. Inflation, Stagflation, Relative Prices, and Imper­
fect Information, Cambridge University Press, Cambridge, London,
New York (1984), pp. 1056-70.
Cukierman, Alex, and Allan Drazen. “ Do Distortionary Taxes In­
duce Policies Biased Towards Inflation?: A Microeconomic Analy­
sis,” Tel-Aviv University (August 1986).
Cukierman, Alex, and Allan H. Meltzer. “ A Theory of Ambiguity,
Credibility and Inflation Under Discretion and Asymmetric Informa­
tion,” manuscript, Carnegie-Mellon University (February 1986a).
Forthcoming Econometrica.
________ _ “The Credibility of Monetary Announcements,” forth­
coming in Manfred J.M. Neumann, ed., Monetary Policy and Un­
certainty (Nomos Verlagsgesellschaft, Baden-Baden, Germany,
1986b).
Fellner, William. Towards a Reconstruction of Macroeconomics:
Problems of Theory and Policy (American Enterprise Institute,
1976).
Fischer, Stanley. “ Long Term Contracts, Rational Expectations and
the Optimal Money Supply Rule,” Journal of Political Economy
(April 1977), pp. 191-206.
________ _ “ Contracts, Credibility and Disinflation," Working Pa­
per No. 1339 NBER (April 1984).
Friedman, James. “A Non Cooperative Equilibrium for Super­
games,” Review o f Economic Studies (January 1971), pp. 861-74.

REFEREN CES

-------------- - Oligopoly and the Theory of Games (North Holland
Publishing Company, Amsterdam, New York, Oxford, 1977).

Alesina, Alberto, and Guido Tabellini. “ Rules and Discretion with
Non Coordinated Monetary and Fiscal Policies,” manuscript (Sep­
tember 1985).

Goodfriend, Man/in. “ Monetary Mystique: Secrecy and Central
Banking,” Journal o f Monetary Economics (January 1986), pp. 6 3 92.

Backus, David, and John Driffill. “ Inflation and Reputation,” Ameri­
can Economic Review (June 1985a), pp. 530-38.

Haberler, Gottfried. “ Notes on Rational and Irrational Expecta­
tions,” Reprint No. 111, American Enterprise Institute (March
1980).

_________ “ Rational Expectations and Policy Credibility Following
a Change in Regime,” Review of Economic Studies (1985b), pp.

211-21.
Barro, Robert J. “ Reputation in a Model of Monetary Policy with
Incomplete Information,” manuscript, University of Rochester
(February 1985). Forthcoming Journal of Monetary Economics.

Hardouvelis, Gikas A. “ Market Perceptions of Federal Reserve
Policy and the Weekly Monetary Announcements,” Journal of
Monetary Economics (September 1984), pp. 225-40.
Hetzel, Robert L. “ The Formulation of Monetary Policy,” manu­
script, Federal Reserve Bank of Richmond (August 1985).

Barro, Robert J., and David B. Gordon. “ Rules, Discretion and
Reputation in a Model of Monetary Policy,” Journal of Monetary
Economics (July 1983a), pp. 101-22.

Kane, Edward J. “ Good Intentions and Unintended Evil: The Case
Against Selective Credit Allocation,” Journal of Money, Credit and
Banking, Part 1 (February 1977), pp. 55-69.

________ _ “ A Positive Theory of Monetary Policy in a Natural Rate
Model,” Journal of Political Economy (August 1983b), pp. 589-610.

________ _ “ Politics and Fed Policymaking: The More Things
Change the More they Remain the Same," Journal of Monetary
Economics (April 1980), pp. 199-212.

Beck, Nathaniel. “ Presidential Influence on the Federal Reserve in
the 1970s,” American Journal of Political Science (August 1982),
pp. 415-45.
Brunner, Karl, and Allan H. Meltzer. The Federal Reserve Attach­
ment to Free Resen/es, House Committee on Banking and Cur­
rency, Washington, D.C. (1964).

_________ “ External Pressure and the Operation of the Fed,” in
R.E. Lombra and W.E. Witte, Political Economy o f International and
Domestic Monetary Relations (Iowa State University Press, 1982),
pp. 211-32.
Kreps, David M., and Robert Wilson.
Econometrica (1982a), pp. 863-94.

“ Sequential Equilibria,"

Bull, Clive. “ Rational Expectations, Monetary Data and Central
Bank Watching,” Giornale degli Economisti e Annali di Economia
(January/February 1982), pp. 31-40.

________ _ “ Reputation and Imperfect Information,” Journal of Eco­
nomic Theory, 27 (1982b), pp. 253-79.

Burns, Arthur F. The Anguish of Central Banking, per Jacobsson
Foundation, Belgrade, Yugoslavia (1979).

Kydland, Finn E., and Prescott, Edward C. “ Rules Rather than
Discretion: The Inconsistency of Optimal Plans,” Journal of Politi­
cal Economy (June 1977), pp. 473-91.

47While there is a substantial amount of descriptive narration (e.g.,
Woolley, 1984; and Hetzel, 1985), there is very little analytical
discussion of these issues.


16


Lombra, Raymond E. “ Monetary Policy: The Rhetoric Versus the
Record,” in Monetary Reform and Economic Stability, Hearings
before the Joint Economic Committee, 98th Cong., 2nd Sess.
(U.S. Government Printing Office, May 16 and June 5, 1984), pp.
101-35.

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1986

________ , and Michael Moran. “ Policy Advice and Policymaking
at the Federal Reserve,” Carnegie Rochester Conference Series
on Public Policy (1980), pp. 9-68.

Rogoff, Kenneth. “The Optimal Degree of Commitment to an Inter­
mediate Monetary Target," manuscript, University of Wisconsin
(1985), forthcoming, Quarterly Journal of Economics.

Lucas, Robert E., Jr. “ Some International Evidence on OutputInflation Tradeoffs,” American Economic Review (June 1973), pp.
326-35.

Taylor, John B. “ Aggregate Dynamics and Staggered Contracts,”
Journal of Political Economy (February 1980), pp. 1-23.

Mayer, Thomas. “ A Case Study of Federal Reserve Policymaking:
Regulation Q in 1966," Journal of Monetary Economics (Septem­
ber 1982), pp. 259-72.
McCallum, Bennett T. "Credibility and Monetary Policy,” in Price
Stability and Public Policy — A Symposium Sponsored by the
Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming
(August 2 and 3,1984).
Pierce, James L. “ Making Reserve Targets Work,” in Controlling
Monetary Aggregates III, Federal Reserve Bank of Boston Confer­
ence Series (1980), No. 23.




________ _ “ Comments on 'Rules, Discretion and Reputation in a
Model of Monetary Policy’ by Barro and Gordon,” Journal of
Monetary Economics (July 1983), pp. 123-25.
Weintraub, Robert E. “ Congressional Supervision of Monetary Pol­
icy," Journal of Monetary Economics (April 1978), pp. 341-62.
Willet, Thomas D., and John McArthur. “Theories of Central Bank
Behavior and Implications for Monetary Reform: A Constitutional
Perspective," paper presented at the meeting of the Western
Economic Association, June 30-July 4,1985, Anaheim, California.
Woolley, John T. Monetary Politics — The Federal Reserve and the
Politics of Monetary Policy (Cambridge University Press, Cam­
bridge, London, New York, 1984).

17

MAY 1986

FEDERAL RESERVE BANK OF ST. LOUIS

Adjusting to High Inflation: The
Israeli Experience
Zalman F. Shiffer

D

URING th e last d ecad e, m any co u n tries have
ex p erien ced relatively high rates o f inflation. In re­
sp o n se to th is p ersistin g p h e n o m e n o n , p eo p le have
ch a n g ed th e ir p ay m en t habits, re stru ctu re d th e ir
portfolios an d in creasin gly resorted to d ifferent form s
o f in d exatio n .1 Sin ce inflationary ep iso d es have dif­
fered a cro ss co u n tries, it is n o t su rp risin g to find
variations in th e degree and n atu re o f in flatio n aiy
a d ju stm en t a cro ss co u n tries.
T h e Israeli ex p e rie n ce w ith inflationary a d ju stm en t
is o f p a rticu lar in terest b eca u se Israel h as ex p erien ced
relatively long, high an d variable in flatio n and, in
resp o n se, h as developed an elabo rate system o f in ­
flationary ad ju stm en t. Israel e x p e rie n ce d two period s
o f high inflation d uring W orld W ar II an d d uring th e
first y ears o f its in d e p en d e n ce: th e an n u al rate of
inflation averaged abou t 27 p e rce n t betw een 1939 an d
1943 an d abou t 34 p e rce n t betw een 1950 an d 1953.
B etw een 1954 an d th e en d o f th e 1960s, th e rate o f
inflation w as red u ced to a relatively m ild 5 p e rce n t p er
y ear. In th e 1970s, how ever, inflation a cc elera ted rap ­
idly (see table 1); it averaged abou t 40 p e rce n t p e r y ea r
b etw een 1973 an d 1 9 7 8 ,1 2 5 p e rce n t b etw een 1979 and
Sep tem b er 1983, and over 400 p e rce n t during 1984r In

Zalman F. Shiffer is a senior economist at the Bank of Israel and a
former visiting scholar at the Federal Reserve Bank of St. Louis. The
author wishes to thank Leslie Bailis Koppel and David J. Flanagan for
research assistance and the members of the Research departments at
the Federal Reserve Bank of St. Louis and the Bank of Israel for helpful
comments. The views expressed in this article do not necessarily
reflect the views of either institution.
’ For discussions of the costs and consequences of inflation, see
Fischer (1981), Fischer and Modigliani (1978), Kleiman (January
1984) and Tatom (1976).
2For discussions of the acceleration of inflation in Israel, see Bruno
and Fischer (1984), Fischer (1984, 1985), Liviatan and Piterman
(1984) and Shiffer (1982).


18


Ju ly 1985, th e Israeli gov ern m en t em b arked on a
stabilization program , w h ich h as red u ced inflation to
an an n u al rate o f 27 p e rce n t b etw ee n Ju ly 1985 an d
May 1986.
T h e Israeli p u blic an d its govern m en t have re­
sp o n d ed to th is in flation ary ex p e rie n ce in a variety o f
w ays?
1)

The introduction and application of indexation to
a wide variety of econom ic transactions. Wage
indexation was introduced during World W ar II.
During the 1950s, the government indexed both its
long-term debt and long-term loans to the public;
indexation of life insurance was also introduced.
In 1975, indexation was applied to tax brackets and
tax exemptions. In addition, indexation is now
applied to other transactions, including co n stru c­
tion and rental contracts, som e short-term loans,
and property insurance.

2) Variations in the use of indexation. Thus, for exam ­
ple, indexation of long-term loans from the govern­
ment to the public was practically abandoned in
the 1960s and gradually reintroduced in the 1970s.
3) Variations in the frequency of price and other ad ­
justm ents. Thus, for example, the frequency of
payment of the Cost of Living Allowance on wages
increased from every six months in the mid-1970s to
every m onth by the end of 1984.
4) Variations in the “rate of indexation,” i.e., in the
extent to which indexed prices were adjusted.
Thus, the rate of indexation for wages increased
from 70 percent in the m id-1970s to 80 -9 0 percent
in the 1980s; at the sam e time the rate of indexation
of lax brackets increased from 70 percent to 100
percent.
3The Israeli government has played a relatively large role in Israel’s
adjustment to inflation. For additional discussion of the adjustment
of the Israeli economy to inflation, and, in particular, of the problems
of indexation, see Brenner and Patinkin (1977), Cukierman (1985),
Fischer (1985), Kleiman (1977, July 1984), Oded Liviatan (1982,
1985), Shiffer (1984) and Sokoler (1985).

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1986

Table 1
Inflation in Israel 1960-84
(annualized changes in the CPI, based
on December data)
Period
1960-69
1970-72
1973-74
1975-76
1977-78
1979-80
1981
1982
1983
1984
1985 (Aug.-Dee.)
1986 (Jan.-May)

Rate of Inflation
5%
12
40
30
45
122
101
131
191
445
37
17

SOURCE: Central Bureau of Statistics: "Statistical Abstract of
Israel.”

5) Tax reforms aimed at imposing corporate incom e
taxes on inflation-adjusted profits.
6) Intensive financial innovation and im portant
changes in the structure of financial portfolios.
7) Changes in the mix of econom ic activity su ch as the
allocation of m ore econom ic resources to financial
and tax management.

T h e p u rp o se o f th is a rticle is to d isc u ss so m e
p ro b lem s th at Israel h as faced u n d e r co n d itio n s o f
high an d rising inflation, h o w it h as tried to a d ju st to
th em , an d so m e sh o rtco m in g s o f th e so lu tio n s
ad o p ted w ith sp e cia l re feren ce to th e last d ecad e. T h e
first se c tio n d iscu sse s, in g en eral term s, th e effects o.
inflation o n p rice a d ju stm en t an d th e u se o f in d e x ­
ation . T h e n ex t se c tio n d eals w ith w age in d exatio n in
Israel an d d isc u sse s th e effects o f th e ad o p tio n o f
partial in d exatio n . T h e th ird se c tio n investigates th e
effects o f inflation o n taxatio n an d th e p artial a d ju st­
m en t o f th e tax sy stem to in flation in Israel. In th e
fou rth sectio n , w e analyze how fin an cial an d asset
m arkets have re a cte d to in flatio n u n d e r co n d itio n s o f
im p erfect a d ju stm en t in th e tax system an d in govern­
m e n t fin an cial tra n sa ctio n s.

PRICE ADJUSTMENTS AND
INDEXATION: SOME GENERAL ISSUES
The Frequency o f Price Adjustments
In m o st m arkets, p rice s are n o t co n tin u o u sly ad ­



ju ste d to ch a n g es in d em a n d a n d su pply; rath er, th ey
are m ain tain ed for a certa in p eriod o f tim e before
bein g a d ju sted by sellers, bu yers, n eg o tiato rs o r regu ­
lators. P rice-sette rs d ecid e h o w often to ch a n g e p rices
by co m p arin g tw o kinds o f co sts a sso cia te d w ith su ch
ch an g es: (a) th e c o s t o f ch an g in g th e p rice, in clu d in g
p o ssib le re a ctio n s o f cu sto m e rs, co m p etito rs an d the
g en eral p u b lic (or th e a u th o rities)4, an d (b) th e lo ss
a sso cia te d w ith n o t a d ju stin g th e existin g p rice in
view o f ch an g in g m arket co n d itio n s. T h e p rice w ill be
ch a n g ed w h en th e la tte r outw eigh s th e form er.
Any p rice th at rem ain s u n ch a n g e d d urin g an in ­
flationary p eriod d e crea se s relative to th e p rice s th at
are rising. C on sequ en tly, p rice -se tte rs ty p ically will
find th at u n ch a n g ed p rices w ill deviate m o re rapidly
an d by larger a m o u n ts from th e ir (changing) op tim al
p rices, th e h ig h er th e rate o f inflation. T h ey w ill also
find th at th e ir cu sto m e rs w ill in cre a s e th e ir p u rch a se s
w h en p rice s are relatively low , forcin g larger flu ctu a ­
tio n s in th e p rice -s e tte r’s p ro d u ctio n o r in ven to ries.5
H ence, it is n o t su rp risin g that, as in flatio n h a s a c c e l­
erated , Israeli p ro d u cers have a d ju sted th e ir p rices
m ore frequently.6 T h e Israeli governm ent h as also
a d ju sted m o re frequ en tly its m an aged rate o f foreign
exch an ge, th e p rices o f its services an d th e p rice s o f
private goods th at it regulates.

Price Adjustment Rules
T h e adm inistrative c o st o f p rice a d ju stm e n t ca n b e
red u ced if th e p rice is a d ju sted ro u tin ely a cco rd in g to
som e relatively sim p le rule. T h e c h o ic e o f a par ticu la r
p rice a d ju stm en t ru le d ep en d s on o p eratin g co sts of

•■Customers generally find frequent price adjustments inconvenient;
moreover, price-setters may be uncertain about the reactions of
their competitors as well. In addition, public opinion sometimes
condemns price increases because the public believes that they are
"unfair” or because they believe in the cost-push view of inflation. In
Israel, the public especially opposed increases in the prices of
government-controlled food items.
5ln one famous episode, the Israeli public began hoarding public
telephone tokens when it recognized that the adjustment of token
prices was long overdue. The government, which owns the tele­
phone company, “ refused to give a prize to speculators” ; instead of
raising the price of the tokens, it produced more tokens. Of course,
these immediately disappeared from the market as well. Thus, the
government incurred unnecessary production costs for the “ extra”
tokens and kept the prices of its service too low for too long.
Meanwhile, the general public chose to hoard the tokens rather than
to use the public telephone system. When the government finally
raised the price of the tokens, they reappeared in the market.
6For rigorous discussions of the conditions under which this reaction
will prevail, see Galyam and Hanoch (1984) and Sheshinski and
Weiss (1977, 1983). Galyam and Hanoch (1984) report that the
average frequency of private price adjustments in Israel increased
from 3.3 times per year in 1973 to 5.1 times per year in 1979.

19

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1986

alternative ru les, an d o n th e ex ten t to w h ich th ey
app roxim ate th e p ath o f p rice ch an g es th a t w ould
b e ch o se n if th ere w ere no a d ju stm en t co sts. In certa in
ca ses, th e p rice -se tte r m ay even d ecid e to a n n o u n ce
h is p rice a d ju stm en t ru le to provide p o ten tial c u s ­
tom ers w ith useful inform ation.

As a n alternative, p a rties to a co n tra ct ca n in d ex
future p ay m en ts u sin g so m e m u tu ally agreeable
m eth o d . In th is ca se th e re is n o u n certa in ty abou t the
real value o f fu tu re p ay m en ts (m easu red in term s o f
th e stan d ard u sed fo r in d exatio n ); th e n o m in a l pay ­
m en ts, how ever, will b e u nkn ow n in advance.

O ne sim ple ru le w ould b e to in crea se p rice s over
tim e at so m e p red eterm in ed rate. T h u s, fo r exam ple,
b etw een m id-1975 an d S e p te m b er 1977, th e Israeli
governm ent devalued th e ex ch an g e rate at an alm ost
co n sta n t rate o f 2 p e rce n t p e r m on th.

T h e c h o ice b etw een th e se tw o sy stem s o f a d ju st­
m e n t d ep en d s o n several co n sid era tio n s:

As an alternative, p rice ad ju stm en t ca n b e b a se d on
indexation; p rices ca n be in crea sed by a p ercen ta g e
th at is eq u al — o r at le ast related — to th e rate o f
ch an g e o f a sp ecific stan d ard (for exam p le, a p rice
index). T hu s, co n stru ctio n co n tra cto rs in Israel often
in d ex th e ir p rices to th e “co st o f co n stru c tio n in d ex.”
In re ce n t y ears, m an y firm s an d trad ers have started
q u oting th e ir p rice s in term s o f U.S. dollars. T h is
a m o u n ts to a daily ad ju stm en t o f th e Shekel (Israeli
curren cy) p rice in term s o f ch an g es in th e rate of
ex ch an g e b etw een Shekels an d U.S. dollars. B etw een
1979 an d 1982, th e govern m ent generally carried ou t a
p o licy o f “in d exatio n " o f th e rate o f ex ch an g e. A cco rd ­
ing to this policy, th e Israeli cu rre n cy w as devalued at
th e rate th a t w as roughly equal to th e d ifference
b etw een th e d o m estic an d foreign rates o f inflation,
th u s, trying to stabilize th e relative p rice o f trad eab le
vs. o th e r goods.

The Use o f Indexation in Credit
Transactions and Future Contracts7
T h e m ost im p ortan t use o f in d exatio n in Israel has
b e e n in cred it tra n sa ctio n s an d o th e r fu tu re co n tra cts
— situ atio n s th at involve co n tra ctu a l obligations for
future paym ents. Parties to su ch co n tra cts are g e n er­
ally co n c e rn e d w ith th e real value o f pay m ents (i.e.,
th e p rice deflated value), an d n o t w ith th e ir n o m in al
value. If they ex p e ct th e gen eral p rice level to ch an ge,
th ey ca n a d ju st th e n o m in al value o f th e stip u lated
future p ay m en ts to achieve th e ir d esired fu tu re ex ­
p e cte d rea l level. T hu s, in th e ca se o f a loan, th e p arties
can add an “e x p e cted in flatio n aiy p re m iu m ” to the
rate o f in terest. If th e rate o f inflation deviates from its
ex p ected level, how ever, th e real value o f th e future
pay m en ts w ill be d ifferent from th at assu m ed w h en
the co n tra ct w as m ade.

7For references to the large body of literature dealing with problems
of indexation, see, for example, Dornbusch and Simonsen (1983)
and Fischer (1983) and McNelis (1985).


20


(1) The confidence that the public has in its exp ecta­
tions about the behavior of prices during the con­
tract period. This confidence depends on the ex­
pected variation in the rate of inflation and on the
length of the con tract period.
(2) The extent to which the value of the parties’ portfo­
lios and their flows of incom e and consum ption
react to changes in prices. Thus, for exam ple, if a
borrow er expects that the nominal value of his
incom e and assets will not be affected by variation
in the rate of inflation during the loan period, he
will be reluctant to index his loan.8
(3) The perceived cost of introducing and operating
indexation. This cost depends on the degree to
which indexation arrangem ents have been used in
the econom y in the past.

Criticisms o f Indexation in an
Inflationary Environment
T h e u se o f in d exatio n is so m etim e s criticiz ed o n th e
grou n d s th at it m ay n o t p ro d u ce th e sam e resu lts th at
w ould o c c u r u n d e r frequ en t, lo w -co st re a d ju stm e n ts.
T h is criticism applies, in p rin cip le, to all p re ­
d eterm in ed form u las fo r p rice a d ju stm en t, an d
sh ould b e w eigh ed against th e b en efits o f co n tra ctu a l
relatio n sh ip s. In d exation , how ever, is different from
o th e r p rice a d ju stm en t form ulas, b e c a u se it m ay p ro ­
d u ce relative p rice rigidities th at c a n n o t b e overcom e
bv h ig h er rates o f inflation (un less in d exatio n is in ­
com p lete). T h is p rob lem is esp ecially a cu te w h en the
eco n o m y is s u b je ct to strong, n on -reversib le sh o ck s
like th e energy p rice sh o ck s in th e 1970s. By retard ing
the a d ju stm en t o f relative p rices, in d exatio n m ay
co m p o u n d th e real effects o f su ch sh o ck s
It h as so m etim es also b e e n argued th a t in d exatio n
in tro d u ces an in flatio n aiy b ias in to th e eco n o m y . By
ex acerb atin g th e p ro c e ss o f th e e c o n o m y ’s a d ju stm en t
to a n o n -rev ersib le ex o g en o u s sh ock, for exam p le,

6Since, by assumption, his assets and incomes are not indexed, he
will obviously lose wealth from unexpected inflation; however, his
loss would be greater if his obligations were indexed. See Levhari
and Liviatan (1977).
9See Gray (1976).

FEDERAL RESERVE BANK OF ST. LOUIS

in d exatio n m ay in cre a se u n em p lo y m en t an d crea te
p ressu res for m ore ex p an sio n ary p o licies. M oreover,
b e c a u se in d exatio n tran sm its p rice ch an g es rapidly
th rou gh o u t th e eco n om y, th ereby au gm en ting the
sh o rt-ru n effects o f tem p o rary d istu rb an ces on th e
g en eral p rice level, it m ay crea te p re ssu res for a c c o m ­
m o d atin g p o licies. Finally, to th e ex ten t th at it re d u ce s
th e p erceived co sts o f inflation, in d exatio n m ay
w eaken th e p u b lic’s o p p o sitio n to inflation.
On th e o th e r h and , it m ight be argued that, if th e tax
sy stem an d govern m ent d ebt are ind exed , th e govern­
m en t will have less incentive to crea te inflation. Also,
th e c o st o f anti-inflation ary p o licies co u ld be low er
w h en co n tra cts are ind exed , sin ce u n e x p ecte d d isin ­
flation w ill n o t ca u se u n e x p ecte d in crea ses in th e real
value o f w ages an d in tere st p ay m en ts.10

Multiple Indexation Standards
W hile it m ight seem co n v en ien t to u se a single
stan d ard o f in d exatio n for all p u rp o ses, su c h a u n i­
form in d ex w ill n o t b e op tim al for all tra n sa ctio n s if
d ifferent p rices rise at different rates. In su ch cases,
m u ltip le in d exatio n stand ard s m ay b e p referable; th is
h a s o cc u rre d in Israel. T h e Israeli governm ent im ­
p o ses in d exatio n to th e c o n s u m e r p ric e index (CPI) in
m o st o f its ow n tra n sa ctio n s and in co n tra cts th at it
regu lates. T h e private s e c to r also u ses th e CPI to in d ex
so m e o f its tra n sa ctio n s. In d ex atio n to sp ecific indus­
try p ric e indexes, how ever, is also u sed , esp ecially in
co n stru c tio n c o n tra c ts.11 O ccasionally, p eo p le will u se
som e ad h o c index th at reflects co n d itio n s a ss o c i­
ated w ith a sp ecific co n tra ct m o re clo sely th a n do th e
g en erally p u b lish ed p rice in d exes. Finally, in d exatio n
to th e rate o f ex ch an g e o f a fo re ig n c u rre n c y (chiefly
th e U.S. dollar) h as b e c o m e m ore p o p u lar in re cen t
y ears. It is esp ecially co m m o n in sh o rt-term fin an cial
tra n sa ctio n s and in tra n sa ctio n s b etw een private n o n fin an cial parties. Firm s engaged in foreign trad e also
in d ex th e ir tran sactio n s to th e rate o f exch an ge.
C on sid eratio n s governing th e c h o ice o f th e sta n d ­
ard o f in d exation d ep en d on th e n atu re o f th e tra n s a c­
tion involved and, in p rin cip le, are sim ilar to th o se

10This effect is stronger, the higher is the rate of indexation and the
frequency of its application. See Fischer (1983) and Friedman
(1974).
"T he government had rejected proposals to index its loans to specific
industry indexes. Proponents of this type of indexation argued that it
would both reduce the industries’ risks and suppress price in­
creases, because price-setters who raised prices would be penal­
ized by higher debt repayment. The obvious drawback of this type of
indexation is that it creates incentives for inefficient resource use.




MAY 1986

affecting th e c h o ice b etw een in d exa tio n an d n o m in al
p rice a d ju stm en t form ulas d iscu sse d above. Sin ce
different in d exes m ay in cre a s e at different rates (esp e­
cially in th e sh o rt run), th e c h o ic e o f th e in d exatio n
stan d ard affects th e allo ca tio n o f risk b etw een the
p arties to a c o n tra c t.12
In Israel, th e ex ten t o f th e u se o f d ifferent stan d ard s
o f in d exatio n h a s varied over tim e in rea ctio n to
ch a n g es in th e m ix o f ec o n o m ic activity an d th e
ex p e rie n ce w ith th e p erfo rm an ce o f different in d exes.
T h u s, for exam ple, th e u se o f th e U.S. d o llar as a
stan d ard o f in d exatio n d eclin ed su b stan tially follow ­
ing a large devaluation in th e early 1960s; it h as
regain ed pop u larity w ith th e tra n sitio n to frequ en t
devaluations sin ce th e m id -1970s. In re c e n t y ears, this
in d exatio n h a s sp read rapid ly for tw o re a so n s. First, it
allow s frequ en t a d ju stm en ts sin ce th e rate o f ex ­
ch an g e is ch an g ed an d p u b lish ed daily; p rice in d exes,
on th e o th e r hand , are ca lcu la ted m on th ly an d p u b ­
lish ed w ith a tw o-w eek delay. At h ig h er ra tes o f in ­
flation th e value o f frequ en t p rice a d ju stm en ts o u t­
w eighs th e disadvantage o f u sin g an in d ex th at m ay
n o t reflect exactly th e co sts an d reven u es o f th e
co n tra ctin g p arties. Seco n d , th e u se o f foreign ex ­
ch an g e as a stan d ard o f d eferred p ay m en ts w as also
en h a n c e d by its in crea sed u se as a m e a n s o f ex ch an g e
an d a tem p orary a b o d e o f p u rch a sin g p o w er (see
below ).

WAGE INDEXATION
W age in d exatio n w as in tro d u ced to Israel d uring
W orld W ar II. It is b a se d on a C ost o f Living A llow ance
(COLA) ag reem en t n eg o tiated b etw een th e la b o r u n ­
ions asso cia tio n an d th e m a jo r private em ployers
asso cia tio n . T h e p rovision s o f th e COLA a g reem en t are
exten d ed , by governm ent d ecree, to w orkers an d em ­
ployers th at are n o t re p rese n te d at COLA n eg o tiation s.
T h e provisions o f th e COLA have varied co n sid e r­
ably over tim e. T h e ir p re sen t stru ctu re is b a se d on
reco m m en d atio n s o f a co m m ittee esta b lish ed in 1975
by th e governm ent, th e la b o r u n io n a sso cia tio n an d
th e em ployers fed eration . T h is co m m ittee re co m ­
m en d ed th at th e COLA b e a d ju sted at six-m o n th
intervals by 70 p e rce n t o f p ast CPI in crea ses, provided
th at th e CPI h as in crea sed by at le a st 5 p e rce n t d uring

12Generally speaking, the indexation standard is one of the negotiable
provisions of a contract. The choice of the standard depends both on
the perceived risks involved and on the expected rates of increase of
different indexes.

21

FEDERAL RESERVE BANK OF ST. LOUIS

th e relevant p erio d .13 T h e co m m ittee d ecid ed against
100 p e rce n t in d exatio n o n th e g rou n d s that th e COLA
sh ou ld n o t co m p en sa te w age-earn ers for ch an g es in
in d irect taxation an d in foreign p rice s — tw o d istu r­
b a n ce s th at w ere su p p o sed ly a sso ciate d w ith 30
p e rce n t o f th e p rice in c re a se s p rio r to 1975.'4
As th e rate o f inflatio n accelerated , th e m in im u m
interval b etw een p ay m en ts w as red u ced , first to th ree
m o n th s and, by 1984, to o ne m o n th . T h e rate o f
in d exatio n w as also in crea sed ; th e COLA by 1984
provided 80 p e rce n t co m p en satio n for a ccu m u la ted
CPI in crea ses o f at le ast 12 p e rce n t d uring o n e m o n th
o r m ore, an d 90 p e rce n t co m p en satio n if th e CPI
in crea sed by 25 p e rce n t in a single m o n th .
T h e p arties did n o t alw ays abide strictly to th e
form al COLA. T hu s, in som e p erio d s o f u n a n ticip a ted
a ccelera tio n in inflation, th e w orkers received ad d i­
tion al ad h o c p aym ents. O n th e o th e r h and , th e lab or
u n io n s a c c e p te d a re d u ctio n in th e rate o f in d exatio n
at th e en d o f 1984 an d b eg in n in g o f 1985 as a p art o f an
an ti-inflationary “package d eal.” In Ju ly 1985, COLA
pay m en ts w ere su sp en d ed for th ree m o n th s in the
early stage o f th e an ti-in flatio n aiy program . T h e
form er COLA ag reem en t w as rein tro d u ced thereafter,
as th e m inim u m p rice in crea se n e c e s s a iy to trigger
pay m en ts w as even red u ced to 4 p e rce n t. In M ay 1986,
however, the rate o f in d exation w as red u ced to 70
p e rce n t and th e trigger in crea sed again to 7 p ercen t.
As a resu lt o f th e different co n stra in ts to w h ic h it
h a s b ee n su b je ct, th e COLA generally h as n o t co m p e n ­
sated Israeli w orkers fully fo r p ast p rice in crea ses.
A ccord ing to so m e calcu latio n s, real w ages w ould
have d ecrea se d by an average o f ab o u t 9 p e rce n t per
y e a r b etw een 1973 an d 1982 if w ages w ere in crea s ed
only acco rd in g to th e COLA arran g em en ts (and in ­
flation w as u naffected ).15 D ue to o th e r w age co m p o ­
n en ts, real w ages in effect ro se by so m e 25 p e rce n t in
that period.

13This constraint (which formerly had been a 3 percent threshold)
turned out to be ineffective because inflation was higher than 5
percent. For other properties of the COLA agreement see Kleiman
(July 1984) and Liviatan (1982).
14Over the years, there have been heated discussions about the
purpose of wage indexation in Israel. Some have argued that it
should prevent real wage erosion; others have argued that it should
maintain the share of wages in national income. The decision of the
1975 committee was closer to the latter view; it could also be
interpreted as an attempt to compensate workers only for monetary
disturbances and not for real disturbances. See Gray (1976) and
Kleiman (July 1984).
15See Kleiman (July 1984) and Liviatan (1982).

Digitized for
22FRASER


MAY 1986

W age in d e x a tio n in Israel provides, how ever, a c o n ­
ven ien t in terim w orking ru le for th e a d ju stm en t o f
w ages b etw een co n tra cts th at are n eg o tiated a n n u ­
ally o r b i-an n u ally. In th e se n eg o tiation s, lab or and
m an ag em en t agree o n a b a sic w age rate, w h ic h th e n
w ill b e au to m atically a d ju sted by th e COLA d uring the
co n tra ct p eriod . T h e p a rties are aw are th at th e COLA
d o es n o t fully co m p e n sa te th e w orkers fo r p ast p rice
in crea ses, an d th e w age n eg o tiatio n s are affected by
th e p a rtie s’ estim a te o f th e e x p e cte d ero sio n o f th e real
w age level d uring th e co n tra ct p erio d . T h e h ig h er the
ex p e cted rate o f in flatio n a n d th e lo w er th e rate o f
in d exation , th e h ig h er is th e in cre a se in th e b a se w age
rate agreed u p o n in th e w age co n tra ct. M oreover, th e
h ig h er th e rate o f real w age ero sio n d ue to th e in a d e­
q u acy o f th e COLA, th e g rea ter is th e real w age
in crea se derived from o th e r co m p o n e n ts o f th e w age
c o n tra ct.16
T h e p artially in d exed w age d eterm in a tio n sy stem in
Israel h as tw o a d d itio n al effects. First, it crea te s a cy cle
in real w ages; th e y re a c h th e ir m axim u m level w h en
th e n ew co n tra ct is sign ed an d fall th ereafter. T h e re
are also sm a ller cy cles b etw ee n COLA a d ju stm en ts. At
high rates o f inflation, th is sy stem p ro d u ces c o n sid e r­
able flu ctu a tio n s in real w ages. U n d er su ch c o n d i­
tions, w orkers c a n e ith e r a d ju st th e ir real ex p en d itu re
p a ttern s o r stabilize th eir real ex p e n d itu re s over tim e
by ad ju stin g th e ir fin an cial p ortfolios.
Secon d , b e c a u se th e p a rties to th e w age co n tra ct
ca n n o t an ticip a te exactly th e ra te o f in flation, th e ir
n eg o tiation s resu lt in th e d eterm in a tio n o f a n e x ­
p e c te d average real w age rate fo r th e c o n tra c t p erio d . If
th e rate o f in flatio n deviates from its e x p e cte d level,
th e real w age rate w ill b e different from its ex p e cted
level, p ro d u cin g d isequ ilibriu m in th e la b o r m arket.
T h u s, it is argued th a t in so m e ca s e s th e gov ern m en t
h as d elib erately ad o p ted m o re inflation ary p o licies
aim ed at erro d in g “e x cessiv e” real w age in c re a s e s by
exploiting th e im p erfectio n s o f th e COLA ag reem en t.
U ncertainty abou t future real w age levels obviously
affects b o th th e d em an d an d th e su p p ly o f labor. If
w orkers are m o re risk-averse th an em ployers, th is m ay
resu lt in h ig h er average real w age levels an d lo w er
em p loym en t.
Even if w e a b stra ct from th e last argu m en t, it is cle a r
th a t th e alleged excessiv e real level o f w ages in Isra e l is
n o t d ue to excessiv e in d exatio n , sin c e real w ages have

'6For statistical tests bearing on these relations, see Kleiman (July
1984) and Liviatan (1982).

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1986

Table 2
Average Tax Rates on Wage Income in
Israel, 1976-841
Effective income tax
as percentage of fixed
real wage income at
average 1975 level
1976
1977
1978
1979
1980
1981
1982
1983
1984

13%
12
13
15
17
13
15
15
17

Effective net direct taxes
as percentage of fixed
real wage income at
average 1975 level2
9%
8
9
12
15
10
13
13
15

'Calculated for a married wage-earner with two children.
^Including income taxes, social security contributions and
children’s allowances.
SOURCE: B.O.I. Annual Report 1982 Table V -8 ,1984 Table V-7
(Hebrew).

in crea sed secu larly d esp ite th e real ero sio n d ue to
p artial in d exatio n . On th e o th e r hand , in d exatio n can
b e co n sid ere d as part o f th e inflationary m ech an ism
u n d e r co n d itio n s o f acco m m o d atin g m o n eta iy p o li­
cies. However, as argued above, high w age ind exatio n
ca n also facilitate anti-inflation p o licies by preventing
real w age in crea ses d uring th e d isinflation p ro cess.

THE ADJUSTMENT OF TAXATION TO
INFLATION
Inflation affects taxatio n th rou gh tw o ch a n n e ls: ef­
fective tax rates an d th e tax b ase. B o th are d iscu sse d in
th is sectio n .

Inflation and Effective Tax Rates
Israel h as traditionally taxed n om in al in co m e at
progressive rates — i.e., rates w h ich in crea se w ith th e
level o f n o m in al in co m e. T axpayers w ith u n ch an g ed
real in c o m e drift in to h ig h er tax b rack ets as th e ir
n om in al in co m es in crea se; as a result, they pay a
h ig h er p e rce n tag e o f th e ir in co m e in taxes (the real
value o f ex em p tio n s erod e in a sim ilar fashion). B e ­
ca u se th e effective tax rates o n different in co m es do
n o t in cre a se p ro p o rtio n ally d uring inflation, th e after­
tax d istribu tion o f in co m e is affected as well.
Up to 1975, th e a d ju stm en t o f Israeli tax b rack ets



an d exem p tio n s to inflation w as essen tially ad h o c.
Sin ce th en , th ey have b ee n form ally in d exed to the
CPI. B etw een 1975 an d 1979, tax b rack ets a n d ex em p ­
tio n s w ere raised at six-m o n th intervals by 70 p e rce n t
o f th e p ast p e rio d ’s inflation. In 1979—80, th e degree o f
in d exatio n w as raised to 100 p e rce n t an d the fre­
qu en cy o f its a p p lication in crea sed to eveiy th ree
m o n th s. In 1984, th is freq u en cy w as in crea s ed to
m a tch th at o f th e COLA p aid on w ages. As sh o w n in
table 2, how ever, in co m p le te in d exatio n o f tax b ra ck ­
ets and exem p tio n s h as resu lted in an in crea sed tax
b u rd en for w a g e-ea m ers w ho, u nlike so m e o th e r tax­
payers, ca n n o t p o stp o n e th e ir tax p ay m en ts. T able 2
show s also th a t a ccelera tio n s o f in flation in 1 9 7 9 -8 0
a n d 1984 w ere a cco m p a n ie d by in crea ses in th e tax
b u rd en (its fall in 1981 w as d ue to an extra a d ju stm en t
o f th e brackets).
T h e effective rates o f tax atio n d ep e n d o n m o re th a n
th e a ctu al rates alo n e; th ey are also affected by th e lag
betw een th e tim e w h en th e tax liability is crea te d an d
w h en it is paid, an d o n th e in tere st ra te ch arged for
th at period . T h e req u ired freq u en cy o f tax paym ents,
as w ell as th e in terest rates an d lin es ch arged on tax
arrears, w ere only gradually a d ju sted w h en inflation
a ccelera ted . As a resu lt, m an y taxpayers w ere able to
re d u ce th e real value o f th e ir ta x p ay m en ts. A ccord in g
to Bank o f Israel (B.O.I.) estim ates, th is effect p ro d u ced
a $480 m illion red u ctio n in real tax revenue as in ­
flation a ccelera ted from 190 p e rce n t in 1983 to 445
p e rce n t in 1984. T h is a m o u n ts to abou t 2 p e rce n t o f
GNP, ab o u t eq u al to th e govern m en t revenu e from
m o n ey crea tio n in re ce n t y ears.

The Tax Base
B u sin ess taxatio n in Israel h a s trad itio n ally b ee n
b a sed on th e d ifference b etw een gross revenue an d
n om in al h isto rical co sts in cu rred in p ro d u cin g this
revenue. U nder co n d itio n s o f p rice stability, th is base
is a reason ab le ap p roxim ation for th e th e o retica l c o n ­
ce p t o f in co m e as th e p o te n tia l in cre a s e in n et w ealth
— th at is, th e am o u n t th at co u ld be co n su m ed w ith ­
out affecting n et w ea lth .17
W hen p rice s in crease, th e d ed u ctio n o f historical
n o m in al co sts o f p ro d u ctio n from taxable in co m e
resu lts in an in cre a s e in th e real ta x b ase, even if th e
real values o f co sts an d sales are u n ch a n g ed . For
exam ple, assu m e that, d urin g a p erio d o f stab le p rices,
p ro d u ctio n c o sts are 350 Israeli Sh ekels at th e b eg in ­

17See Hicks (1946), chap. 14.

23

FEDERAL RESERVE BANK OF ST. LOUIS

n in g o f th e y e a r an d th e p ro d u ct is sold for 500 Sh ekels
at th e en d o f th e y ear. T h e firm ’s taxable in co m e is 150
Shekels o r 30 p e rce n t o f its sales. Now, assu m e in stead
th at all p rice s d ou ble d uring th e y ear, an d th e firm ’s
sales are 1,000 Shekels; its taxable in co m e w ill th u s be
650 Shekels o r 65 p e rce n t o f its sales even th o u g h its
co sts an d sales are u n ch a n g e d in real term s. T h u s, if
in co m e taxatio n is im p o sed o n th e nom inal d ifference
b etw een revenu es an d co sts, rea l n et w ealth will be
taxed at in co m e tax rates that ex ceed the exp licit tax
rates o n w ealth.
O ne im p o rtan t exam p le o f th e effect o f inflatio n on
th e tax b ase is th e taxatio n o f in tere st in co m e. W hen
inflation accelera tes, n om in al rates o f in tere st in ­
crea se to co m p e n sa te fo r th e ero sio n o f th e p rin cip al
lo an ed . T axing th e in flatio n -in d u ced p o rtio n o f th e
in tere st p ay m en ts re su lts in taxing th e p rin cip al o f th e
loan . Sym m etrically, borrow ers w ho ca n d ed u ct the
in flatio n -in d u ced co m p o n e n t o f th e ir in tere st pay ­
m e n ts from th e ir taxable in c o m e receive a tax break.
T h e in flatio n -in d u ced rise in th e n o m in al rate o f
in terest in crea sed th e d ifference b etw een th e b efo re­
tax an d after-tax in tere st rates p aid by b o rro w ers w ho
co u ld b en efit from th e full tax ad vantages.18As a result,
th ere w ere stron g in cen tiv es to re d irect e c o n o m ic
activity and to re stru ctu re p ortfolios to m inim ize in ­
co m e from highly taxable in terest an d to in cre a s e taxd ed u ctib le in tere st p ay m en ts. In particu lar, private
b u sin e sse s relied m o re heavily on d eb t fin an cin g;
in tere st p ay m en ts w ere tax -d ed u ctib le, w h ile divi­
d en d pay m ents w ere not.

Adjustingfo r the Effects o f Inflation in
the Taxation Base
Over th e y ears, th e Israeli govern m ent h as in tro ­
d u ced several m e a su res to co m p en sa te , at le ast p a rti­
ally, for th e effect o f inflation o n th e real tax b ase u sed
for b u sin e ss taxatio n . First, an allo w ance for a c c e le r­
ated estim ates o f fixed cap ital in vestm en t d e p re cia ­
tio n co sts for tax p u rp o ses sh ifted th e tim ing o f tax
p aym en ts to later p erio d s w h en th e real value o f the
given n o m in al pay m ents is low er. Seco n d , allo w an ces
for ex p en d itu res on inventory w ere au th o rized . Third,
low er tax rates w ere applied to som e form s o f

,8The difference between these two rates is equal to (t) x (i), where t is
the tax rate and i is the nominal rate of interest. According to the
B.O.I. calculations, the difference between real before- and after-tax
short-term interest rates increased from 4.5 percent in 1983 to 12
percent in 1984. See B.O.I. Annual Report 1984, table VIII-10.

Digitized for24
FRASER


MAY 1986

“in flatio n -in d u ced n o m in a l rev en u es” — revenu es
th at reflect o n ly th e a d ju stm e n t o f n o m in a l values to
th e ch an g e in p rice s an d th erefo re are n o t real gains.
T h u s, in flatio n -in d u ced cap ital gains w ere taxed at a
relatively low flat rate o f 10 p e rce n t. Sim ilarly, in d ex ­
atio n p ay m en ts on g ov ern m en t-issu ed , in d exed fin an ­
cial assets w ere exem p t from taxes, an d th e h o ld ers of
th e se assets w ere req u ired to pay taxes only o n the
real in terest re ceip ts. F ou rth , th e governm ent has
partially im p o sed in co m e taxation on th e inflationin d u ced in co m e gain ed from low in terest lo an s
g ran ted by b u sin ess to th e ir ow n ers an d em p loyees.
T h e se tax a d ju stm en ts w ere n o t ap p lied universally
a n d w ere o n ly partially rela ted to th e effect o f in flation
on th e ta x b a se. T h u s, th e y did n o t co m p letely n eu tra l­
ize th e adverse effects o f th e ta x sy stem u n d e r in ­
flationary co n d itio n s.
In 1982, Israel a d o p ted th e “T ax atio n u n d e r In ­
flationary C o n d ition s A ct” to e n su re th a t b u sin e ss
taxatio n w ould b e ap p lied only to th e in cre a se in th e
real n et w o rth o f th e taxpayer. To ach ieve th is result,
th e n ew law provided th at:
a) the firm be granted a capital preservation allowance
deduction on the difference between the value of its
assets which are subject to nominal taxation and its
liabilities, if this difference is positive.
b) if the firm’s liabilities are larger than the assets
subject to nominal taxation, a proportional part of its
interest payments will not be tax-deductible.'9

T h e id ea b eh in d th e n ew law, in p rin cip le, w as
sim ple an d elegant. M any o f its provisions w ere c o m ­
plicated , how ever, an d it co n sid erab ly in c re a s e d ef­
forts devoted to tax m an ag em en t. B e c a u se o f th e
am biguity o f som e o f its provisions, m an y firm s d iscov­
ered th at they w ere able to co n tro l th e level o f th e ir tax
retu rn s. In stea d o f in crea sin g tax co llectio n , as th e
g overnm ent h a d in ten d ed , th e n ew a ct resu lted in

,9While some tax payments are deferred, the Israeli firm is, in
principle, subject to full taxation of the nominal appreciation of
certain assets (like inventories) and to taxation of the real (inflationadjusted) appreciation of other assets (like physical capital). On the
credit side of its balance sheet, it can deduct fully the interest (and
indexation) payments on its liabilities, but cannot deduct expenses
against its equity capital.
Under this system, there is no positive or negative taxation of the
firm’s real net worth if the (reevaluated) value of the assets that are
subject to full nominal taxation is equal to its liabilities. However, if
the value of the subject to full nominal taxation assets exceeds (is
less than) the value of the liabilities, the present system results in
partial positive (negative) taxation of the firm’s real net worth. The
intention of the two recommendations was to prevent this positive or
negative real net worth taxation.

FEDERAL RESERVE BANK OF ST. LOUIS

lo w er real tax re ceip ts. T hu s, th e B.O.I. estim ated in its
1984 a n n u al rep o rt th at th e new law red u ced real tax
revenue by th e equivalent o f $350 m illion (about 1.5
p e rce n t o f GNP) b etw een 1983 an d 1984.
In 1985, a co m m ittee ap p o in ted by th e governm ent
reco m m en d ed th e ab a n d o n m en t o f th e tax atio n u n ­
d er th e C on d ition s o f Inflation Act an d th e ad o p tio n of
a n ew system . A ccording to th e se reco m m en d atio n s,
co rp o ra te taxpayers (and so m e o th e r b u sin esses) will
b e requ ired to su bm it rep o rts b ased on a cco u n tin g
ca rried in term s o f U.S. dollars o r c o n sta n t p u rch a sin g
p o w er Shekels (ad ju sted daily). O th er taxpayers will
be req u ired to ad ju st th e ir u n its o f a cc o u n t m o n th ly —
o r even m ore often if inflation rem ain s in th e tw o-digit
m onthly range.
E arly re a ctio n s to th e se re co m m en d atio n s p o in ted
to co n sid erab ly in c re a se d c o sts o f tax m an ag em en t
(with sp e cial difficulties for firm s th at carry th e ir
a cco u n tin g on an accru al ra th er th an a ca sh basis).
T h e ad o p tio n o f th e se re co m m en d a tio n s co u ld have
affected co n sid erab ly th e rest o f th e eco n o m y and, in
particular, im pinged on th e m o n eta iy regim e. Thu s,
co n sta n t-p u rch asin g -p o w e r Shekel a cco u n tin g w ould
have en co u rag ed fu rth er CPI in d exatio n throu ghou t
th e econ om y, w hile D ollar a cco u n tin g w ould have
resu lted in a full "D o llarizatio n ” o f th e Israeli e c o n ­
om y. As m e n tio n e d earlier, th e Israeli eco n o m y had
anyw ay b ee n su b je ct to “craw ling D o llarizatio n ” for a
n u m b er o f y ears.20 In view o f the sizable re ce n t re d u c­
tio n in th e inflation rate, it seem s th at th e se n ew
re co m m en d atio n s w ill not be applied.

THE ADJUSTMENT OF THE
FINANCIAL AND REAL ASSET
MARKETS TO INFLATION
A d ju stm en t o f private p ortfolios o f asse ts an d liabili­
ties to inflation h as b e e n strongly affected by tax
co n sid eratio n s, by th e n atu re o f th e governm ent in ter­
v ention in fin an cial m arkets an d th e in co m p le te ad ­
ju stm en t o f th e g ov ern m en t’s financial activities to
inflation.

Government Intervention in Financial
Markets
T h e Israeli governm ent in tervenes heavily in finan-

?0Between 1983 and 1985, there were heated discussions about the
merits of adopting official Dollarization as a shortcut for rapid
disinflation.




MAY 1986

cial m arkets in attem p tin g to affect th e allo ca tio n o f
re so u rces in th e eco n om y. By clo sely co n tro llin g th e
p ro c e ss o f lon g -term fin an cial in term ed iatio n , th e
governm ent fu n ctio n s, in effect, as a h u ge fin an cial
interm ed iary. It raises fund s d irectly an d in d irectly
from th e private secto r; it u ses p a rt o f th e se p ro ceed s
to fin a n ce its ow n d eficit an d d irects th e re st as lo an s
to private borrow ers u n d e r clo sely co n tro lled co n d i­
tion s. T h e p u b lic s e c to r pays relatively high ra tes o f
retu rn to savers an d a llo ca tes fu n d s to favored activi­
ties su ch as b u sin e ss fixed in vestm en t, ex p o rts an d
h o u sin g at lo w er rates o f in tere st. T h e d ifference
b etw een th e gov ern m en t bo rrow in g an d len d in g rates
re p rese n ts a su bsid y that is fin a n ce d th rou g h th e
g overnm ent budget.
Sin ce th e 1950s, m o st g ov ern m en t b o n d s a n d lo n g ­
term fin an cial savings, w h ic h are largely b a ck ed by
govern m en t b o n d s, have b e e n in d exed (prim arily to
th e CPI).2' S h o rt-term d ep o sits in d e x e d to th e rate o f
ex ch an g e o f different foreign c u rre n cie s are su p p lied
to th e private s e c to r by th e B.O.I. G overnm ent loan
in d exatio n w as also in tro d u ced in th e 1950s, b u t it w as
d isco n tin u ed in th e 1960s an d re in tro d u ce d only
grad ually d urin g th e 1970s (b ecom in g again th e g en ­
eral rule by 1981).“ In ad d ition , th e n o m in al rates o f
in tere st ch arged o n n o n -in d ex ed govern m en t lo an s
w ere only belated ly an d partially a d ju sted to inflation
d uring th e 1970s — as ca n b e see n from table 3 “
As co u ld be ex p ected , firm s an d individuals m ad e
co n sid era b le effort to qualify fo r p u b lic lo a n s offered at
in creasin gly negative real ra tes o f in tere st d urin g th e
1970s. T h e term s o f th e se lo an s h ad im p ortan t, so m e ­
tim es very in efficien t, effects o n th e d ire ctio n o f e c o ­
n o m ic activity an d th e d istrib u tio n o f in c o m e and
w ealth, h in d erin g th e d ev elop m en t o f private cap ital
m arkets an d co n trib u tin g to th e in c re a s e in govern­
m ent d eficits. T h u s, th e 1984 B.O.I. an n u a l report
estim a ted th at th e value o f su b sid ies an d tran sfers
g ran ted by th e au th o rities to cred it bo rro w ers aver-

21Partially indexed government bonds were issued between 1975 and
1982. The partial indexation, however, was applied in a way that
ensured positive real rates of return at any rate of inflation.
^In 1962, a 67 percent devaluation produced a large real increase in
the value of the (then widespread) foreign exchange indexed loans.
The government renegotiated the terms of the loans in favor of the
borrowers. Thereafter, it introduced devaluation and indexation
insurance options whose premiums were relatively low. Thus,
indexation of government loans practically disappeared for many
years.
“ By the end of the period, the low nominal rates of interest shown in
table 3 applied only to a small (and highly subsidized) proportion of
public loans.

25

MAY 1986

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
Inflation and Nominal Rates of Interest in Israel, 1970-82

Period
1970-72
1973-74
1975-76
1977-78
1979-80
1981-82

Average
yearly
rate of
inflation1

Interest
rate on
short-term
“free”
commercial
bank credit2

10%
29
35
42
103
119

16%
22
29
46
162
155

Interest on
subsidized
long-term
loans to
manufacturing3
9%
9
12
19
30
30

Interest on
subsidized
long-term
loans on
mortgages3
7%
8
10
12
12
N.A.

'Increase in average yearly Consumer Price Index (see Table 1 for December to December rales of
inflation).
interest on approved overdraft facilities.
3Over the years, indexation was increasingly applied to subsidized loans, and, by the end of the period,
these low nominal rates applied only to a small part of public loans.
SOURCE: Meir Sokoler (1985).

aged 4 p e rce n t o f GNP in 1 9 7 4 -7 8 , 9 p e rce n t in 1 9 7 9 80, an d 5 p e rce n t in 1 9 8 1 -8 4 . It is difficult, how ever, to
d eterm in e h o w m u ch g overn m ent sp en d in g on su b si­
dies to bo rro w ers reflected d iscretio n ary p o licy and
how m u ch w as th e resu lt o f u n a n ticip a ted inflation .34

The Adjustment o f Private Portfolios
As in crea sed in flatio n raised th e c o st o f hold ing
m oney, p eo p le beg an to e co n o m iz e o n th e ir m o n ey
hold ings in p red ictab le w ays. T h ey ch an g ed th e ir
p ay m en t p atte rn s by m atch in g m o re clo sely th e ir
re ceip ts an d p ay m en ts; th ey in creasin g ly re so rted to
th e u se o f overdraft facilities an d relied m o re on
in terest-b earin g assets, ra th er th a n m oney, as te m p o ­
rary abo d es o f p u rch asin g pow er. T ra n sa ctio n co sts
in cu rred in shifting am ong d ifferent asse ts b e c a m e
relatively u n im p o rtan t w h en co m p ared w ith th e in ­
creasin g d ifferences b etw ee n rates o f retu rn o f m o n ey
an d o th e r a ssets. Table 4 show s h o w th e rea l value of
m o n ey b a la n c e s h as d ecrea se d d uring th e y ea rs o f
high inflation d esp ite positive GNP grow th.

24See Cukierman (1985), Litvin and Meridor (1983) and Sokoler
(1985). Litvin and Meridor estimated that unplanned inflationary
transfers from the government to borrowers averaged about 4
percent of disposable income in 1975-80.


26


As inflation a ccelera ted , th e Israeli p u b lic sh ifted
m ainly from m o n ey to in d exed a sse ts ra th e r th a n to
n o n -in d exed , in terest-b ea rin g a sse ts like tim e d e ­
p o sits an d ce rtifica tes o f d ep o sit (CDs). T h e p u b lic ’s
p referen ce for in d exed m o n ey su b stitu tes w as due, to
a large exten t, to th e availability o f tw o types o f
relatively liqu id in d exed a sse ts — trad eab le CPIin d exed gov ern m en t b o n d s an d sh o rt-te rm d ep o sits
in d exed to th e rate o f ex ch a n g e. T h e se a sse ts served as
h ed ges against u n e x p e c te d in flation. In ad d ition ,
sh o rt-ru n flu ctu a tio n s in th e ir real values w ere kept
for m an y y ea rs w ith in a relatively n arro w ran ge by
official in terven tio n .25
T able 4 show s th a t th e value o f m o n ey a n d u n in ­
d exed sh o rt-term d ep o sits in crea sed co n sid erab ly in
1985. T h is w as d ue to th e steep re d u ctio n in th e rate o f
inflation in th e se c o n d p art o f th e y e a r an d to policyin d u ced in cre a s e s in th e real retu rn on u n in d ex ed
d eposits.

25See Shiffer (1982) for a discussion of this policy. The preference for
government-backed indexed assets was also affected by different
tax treatment of the indexation differentials on these assets and the
nominal interest on unindexed deposits. Correction of this tax
discrimination in the early 1980s increased the demand for unin­
dexed assets; their share in the public’s portfolios, however, re­
mained relatively low until recently.

MAY 1986

FEDERAL RESERVE BANK OF ST. LOUIS

Table 4
Money and Money Substitutes in Israel1,
1970-84 (in millions of Israeli Shekels at
____________
constant 1969 prices)
Period

Money
supply2

Unindexed
money
substitutes3

Indexed
money
substitutes4

1970
1972
1974
1976
1978
1980
1982
1984
1985

302
391
309
280
268
140
113
75
94

243
300
137
81
64
51
136
127
315

418
489
794
649
875
914
1000
1188
958

'Components of the Israeli “ M„” monetary aggregate. December
data.
2“ M,” — currency and non-interest-bearing checking accounts.
3Unindexed time deposits, certificates of deposits and the
“ short-term loan” (an unindexed B.O.I. bill).
4Foreign exchange indexed deposits of Israeli residents in
domestic banks (excluding deposits created by personal
restitution payments from the F.R. of Germany) and marketable
indexed government bonds.
SOURCE: B.O.I. annual reports and other B.O.I. data.

U nd er co n d itio n s o f high an d variable inflation
p eop le are esp ecially re lu ctan t to hold illiquid asse ts
th at do n o t offer a reaso n ab le h ed g e against u n e x ­
p e cte d inflation. S u ch asse ts are n o w p ractically n o n ­
ex isten t in Israel. On th e o th e r h and , th e Israeli p u blic
h as acq u ired co n sid erab le am o u n ts o f fully in d exed
lon g-term fin an cial assets, su ch as clo sed saving d e­
po sits an d d ifferent kinds o f p e n sio n an d in su ran ce
fund s th a t are b ack ed prim arily by govern m ent debt.
Th u s, d esp ite high an d rising inflation, th e govern­
m en t h as b e e n able to fin an ce p art o f its d eficit
throu gh d o m estic d ebt sales. D om estic d ebt fin an cin g
averaged so m e 5 p e rce n t o f GNP in th e 1 9 7 4 -8 4 p erio d
— abou t th e sam e as in th e 1 9 6 8 -7 3 p erio d .26
B esid es in d exed d o m estic fin an cial a ssets, d irect
claim s against foreigners an d p h y sical asse ts can also
serve as h ed ges against inflation. C laim s against for­
eigners ca n be held in th e form o f cash , in tern atio n al
traveler’s ch eck s, d ep o sits abroad, foreign secu rities,

etc. T h e h old ing o f su ch a sse ts is legally lim ited in
Israel, bu t th ere are stron g in d ica tio n s that th e legal
co n stra in ts are n o t alw ays strictly observed. In p a rtic­
ular, foreign ex ch an g e is often u sed illegally as a
m ean s o f p ay m en ts am o n g Israeli resid en ts, o r b e ­
tw een Israeli resid en ts an d foreign visitors. T h is use
ap p aren tly h a s risen in re ce n t y ea rs along w ith th e
in crea sed in d exatio n to foreign ex ch a n g e in th e Israeli
eco n om y. B etw een 1983 an d th e first h a lf o f 1985, the
d em an d for foreign ex ch a n g e in crea s ed a s m an y Is ­
raelis b eca m e co n c e rn e d ab o u t th e p o ssib le taxatio n
o f d o m estic fin an cial a ssets. T h e d em a n d for foreign
ex ch an g e in crea sed also as it b ec a m e evid ent that,
w ith a 400 p e rce n t a n n u al in flatio n rate, m o n th ly
in d exatio n o f m any fin an cial assets to th e CPI m ay n ot
provide ad eq u ate p ro tectio n against inflationary e ro ­
sion . A ccord in g to so m e early in d icatio n s, th e a d o p ­
tion o f th e 1985 stab ilization plan h a s brou gh t about
th e red u ctio n in th e asset d em an d for foreign ex ­
ch an ge.
T h e availability o f in d exed fin an cial a sse ts (and
foreign claim s) h a s re d u ce d th e d em an d for p h y sical
a ssets, like h ousing, as h ed g es against inflation.
Sin ce 1973, th e d em an d for th e se a sse ts also w as
adversely affected by re d u ce d real GNP an d p o p u la ­
tio n grow th. O n th e o th e r h an d , p h y sical in vestm en t
h as b een en co u rag ed by th e availability o f ch e ap
governm ent loan s. T able 5 show s th at th e average
in crea se in th e real value o f p h ysical a sse ts h eld by the
p u b lic h as lagged b eh in d th at o f fin an cial a sse ts (ex­
clu d in g u n reco rd ed claim s against foreigners) b e ­
tw een 1973 an d 1984.
In th e late 1970s an d early 1980s, Israel e x p e rie n ce d
an u n p reced en ted b o o m in its sto ck m arket. T h is
ex p e rie n ce w as, at least, p artially rela ted to th e effects
o f inflation. D ue to th e in flatio n aiy tax atio n o f th e ir
n om in al profits, banking c o n c e rn s suffered lo sses in
th e ir real equity value. In ad d ition , th ey w ere u n ab le to
raise ad equ ate fu n d s th rou g h u n in d ex ed a sse ts an d
w ere n ot allow ed to co m p e te w ith th e gov ern m en t in
th e in d exed bo n d m arket. T h ey resorted , th erefo re, to
m an ip u lation o f th e m arket p rice s o f th e ir sh a re s in
o rd er to in crea se th e attractiv en ess o f n ew sh are
issu es. T h is activity h ad d estabilizin g effects on th e
stock m arket, an d th e ban k s w ere finally fo rced to
d isco n tin u e th e ir m an ip u latio n in O cto b er 1983. At
that tim e, th e real value o f b an k sh a res fell sharply.

CONCLUDING REMARKS
^See Bruno and Fischer (1984) and B.O.I. annual reports, table VIII-2
(1983 and 1984).




T h e Israeli p u b lic an d its gov ern m en t have re ­
sp o n d ed in a variety o f w ays to th e lo n g in flatio n aiy

27

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1986

Table 5
Increase in Financial and Physical
Assets Held by Israeli Public, 1979-84
(real annual growth)
Period
1970-73
1973-78
1978-84
1970-84

Financial
assets

Physical
assets

13.2%
9.7
6.3
9.0

16.7%
6.8
3.8
7.5

Of which
housing
property is
26.8%
6.6
5.7
10.2

SOURCE: Dan Yariv (1984); B.O.I. calculations.

ex p e rie n ce to w h ich th e co u n try h as b ee n su b je ct
and, in particu lar, to th e a ccelera tio n o f in flation over
th e p a st d ecad e. Israel h a s ad o p ted a variety o f so cial
co n triv an ces in ten d e d to red u ce, at least partially,
so m e o f th e effects o f u n a n ticip a ted inflation. T h e
m o st im p o rtan t o f th e se co n triv an ces have b e e n th e
d ifferent in d exatio n d evices d escrib e d in th is article.
T h e a d ju stm en t o f th e Israeli eco n o m y to rising
in flation h as b ee n long, ard u ou s an d in co m p lete. As
p artial m e asu res w ere applied , n ew p ro b lem s em ­
erged; often, p artial a d ju stm en ts crea te d n ew in ef­
ficien cie s. G enerally speaking, th e 1 9 7 0 -8 5 p erio d of
high and rising in flation in Israel h as b ee n c h a ra c te r­
ized by very inten sive fin an cial activity, by freq u en t
shifts o f fin an cial d em an d s b etw ee n m arkets an d by
rapid fin an cial in novation. Firm s, an d individuals to a
le sse r exten t, re stru ctu re d th e ir asse ts and liabilities
to b en efit from th e im p erfect ad ju stm en t in th e pu blic
s e c to r’s fin an cial o p eratio n s an d th e tax sy stem . All
told, co n sid era b le re so u rces w ere invested in financial
an d tax m an ag em en t ra th er th an m o re prod uctive
activities. F o r exam ple, th e sh are o f fin a n ce an d b u si­
n e ss services em p lo y m en t ro se from 5.2 p e rce n t in
1970 to 9.5 p e rce n t in 1984.27
B e ca u se o f its elabo rate in flatio n -ad ju stm en t m e c h ­
an ism s, Israel h as b ee n able to avoid m a jo r ec o n o m ic
breakd ow n s d esp ite its unfavorable in flatio n ex p eri­
e n ce. T h e e c o n o m ic p erfo rm an ce o f Israel h as, how -

27Kleiman (January 1984) and Marom (1986) estimated that some 2 4 percent of 1982 GNP was directed to financial inflation-adjustment
activities.

Digitized for 28
FRASER


ever, clearly d eterio rated in th e 1970s a n d early 1980s.28
W hile o th e r fa cto rs also have co n trib u te d to th is
result, th e re ca n b e n o d o u b t th a t h ig h an d rising
inflation an d im p erfectio n s in in flation a d ju stm en t
have adversely affected e c o n o m ic efficien cy an d c o n ­
trib u ted to th e d eterio ra tio n o f th e co u n try ’s e c o ­
n o m ic p e r fo rm a n c e 29
As a resu lt, th e re h a s b e e n grow ing re co g n itio n in
Israel th at p rice stability is a m o re attractive p o licy
alternative th a n attem p tin g to find w ays to a d ju st to
high in flation.30 T h u s, by m id -1985, Israel b eg an an
am b itiou s an ti-in flatio n ary program th at h a s p ro ­
d u ced m an y en co u rag in g in itial resu lts.
As in flation w en t dow n, p e o p le have beg u n to
ch a n g e grad ually th e h a b its a n d in stitu tio n s th at
w ere ad o p ted d urin g th e high in flation y ears. T h e se
ch a n g es have so far b e e n lim ited by th e p e o p le ’s
c o n c e rn abou t th e p o ssib ility o f rein flation . T h e re is a
stron g feeling th a t in fla tio n -a d ju stm e n t m e ch a n ism s
sh o u ld b e cu rb e d fu rth er in th e fu tu re to su p p o rt a
su stain ab le lo w er rate o f inflation. Som e o f th e
ch a n g es th a t have b ee n a d o p ted u n d e r th e p re ssu re of
inflation, how ever, m ay also prove b en eficia l in a m ore
stab le en v iro n m en t. T h u s, for exam ple, so m e sort o f
fin an cial in d exa tio n m ay co n trib u te to th e sm o o th
a n d efficien t o p era tio n o f lo n g -term fin a n cia l m a r­
k ets."

REFERENCES
Auerbach, Zvi, and Nahum, Patrick. “The Effects of Inflation on Tax
Collection,” The Israeli Tax Review (September 1985), pp. 371-76
(H eb rew ).

Bank of Israel.

Annual reports (Hebrew and English).

Brenner, Reuven, and Don Patinkin. “ Indexation in Israel,” in Erik
Lundberg, ed., Inflation Theory and Anti-Inflation Policy (London:
Macmillan, 1977), pp. 387-416.

“ Israel has avoided the breakdown in its democratic political system
and the massive impoverishment of large social classes that has
often accompanied high-inflation episodes in other countries. The
effect of inflation on Israeli income and wealth distributions, how­
ever, has been far from neutral; in particular, the imperfect adjust­
ment of taxation and government lending policies have produced
important consequences.
“ Thus, real economic growth fell from 10 percent per year in the
1961-72 period to 3 percent in the 1973-84 period (and even less in
the 1980s); the rate of unemployment increased from 3.4 percent in
1970-72 to 5.1 percent in 1982-84 and private savings from all
sources decreased from 36 percent in 1970-72 to 28 percent in
1982-84. The reduction in gross national savings has been much
more acute because of increased government deficits.
“ See Fischer (1985).
31See Shiffer (1984).

FEDERAL RESERVE BANK OF ST. LOUIS

MAY 1986

Bruno, Michael, and Stanley Fischer. “The Inflationary Process in
Israel: Shocks and Accommodation,” in Yoram Ben-Porath,
Michael Bruno and Nadav Halevi, The Economy of Israel: Maturing
Through Crises (The Maurice Falk Institute for Economic Research
in Israel, Jerusalem, July 1984), pp. 508-57.
Cukierman, Alex. “ Indexation and the Political Economy of the
Israeli Inflation,” prepared for the 60th Annual Conference of the
Western Economic Association, Anaheim, California (May 1985).
Dornbusch, Rudiger, and Mario Henrique Simonsen, ed.,
Debt and Indexation (MIT Press, 1983).

Inflation,

Fischer, Stanley. “Towards an Understanding of the Costs of Infla­
tion: II,” in Karl Brunner and Allan H. Meltzer, eds., The Costs and
Consequences of Inflation, Carnegie-Rochester Conference Se­
ries on Public Policy, Vol. 15 (North Holland, Amsterdam, Autumn
1981), pp. 5-41.
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