In this paper we analyze Israel's recent
inflation targeting policies and their role in the disinflation process in the
1990s.Special features of
Israel's economic background underlying inflation targeting are:a high-inflation history which produced
various institutions and mechanisms—such as wage and financial indexation-that
may produce strong inflation persistence;
lack of consensus about the benefits from reducing inflation and thereby
lack of full credibility of monetary policy under inflation targeting;the existence of monetary policy
overburdening in its attempts to meet the inflation targets, especially when
fiscal policy was not compatible with achieving the targets;the coexistence of an exchange
rateband together with the
inflation targets.Since some of
these conditions are not unique to Israel, the analysis is of interest because
they may apply to other countries as well.A key finding of the econometric analysis in the paper is
that there is a time-varying passthrough from exchange rates to prices, which
depends on the state of the business cycle and the size of exchange rate
fluctuations.In particular, a
higher degree of passthrough was found in booms vs. recessions, and a stronger
contemporaneous passthrough emerged under relatively large vs. small exchange
rate movements.In the present
empirical specifications, monetary conditions are shown to have played a key
role in accounting for the various turning points along the disinflation
process.Estimates of an analogue
of a ‘Taylor rule' for the central bank interest rate indicate that in contrast
with the monetary accommodation that prevailed in the past, monetary policy in
the more recent years has acted as an inflation stabilizer.Moreover, in recent years there has
been a growing importance in the role of market-based inflation expectations
and a larger degree of interest rate smoothing in the estimated monetary policy
rule.
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