The Bank of Israel

The Bank of Israel

This page intentionally left blank

The Bank of Israel

Volume 1

A Monetary History

Haim Barkai

Nissan Liviatan

1

2007

1

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Library of Congress Cataloging-in-Publication Data

Barkai, Haim [date]

The Bank of Israel.

p. cm.

Includes bibliographical references and index.

Contents: v. 1. The monetary history of Israel / Haim Barkai

and Nissan Liviatan—v. 2. Selected topics in Israel’s monetary

policy / edited by Nissan Liviatan and Haim Barkai.

ISBN-13 978-0-19-530072-7; ISBN 0-19-530072-6 (v. 1)

ISBN-13 978-0-19-530073-4; ISBN 0-19-530073-4 (v. 2)

1. Bank Yisra’el. 2. Banks and banking—Israel.

3. Money—Israel—History. 4. Monetary policy—Israel.

I. Liviatan, Nissan. II. Title.

HG3260.A7B40 2007

332.4'95694—dc22 2006024501

987654321

Printed in the United States of America

on acid-free paper

To Nurit and Carmela

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Preface

Several years ago, when David Klein had just started his term as governor of the

Bank of Israel, he asked me to edit a book to commemorate the golden anniver￾sary of Israel’s central bank, which had been established in December 1954. My

first reaction was hesitant, but later I was convinced that it would be possible to

embark on a serious research project to commemorate the event. This is especially

the case in Israel, which during those fifty years had completed a cycle in macro￾economic development: loss of control of inflation and the reestablishment of

price stability within the framework of a different monetary system. I saw in the

explanation of this cycle a professional challenge that deserved a research project.

Thus, I returned to the governor with a practical proposition based on the

following principles: (a) The authors shall be given full academic freedom to

express their views, even though the Bank of Israel is financing the project.

(b) To safeguard the objectivity of the research, the editors shall choose the

authors from the ranks of academia, excluding economists and officials of the

bank, and the bank shall pay them at prevailing world rates. (c) To benefit from

the views and experience of the top Bank of Israel officials who implemented

the bank’s policies in the past, the authors shall interview these officials and

summarize their views about the policies undertaken during and after their

terms in office. The Governor accepted these principles willingly and even

made some suggestions about the practical implementation of the project.

I then asked Professor Haim Barkai to join me as coeditor. He is an expert on

the historical background of the establishment of the Bank of Israel and the

conduct of monetary policy over time. He has written extensively on monetary

policy in Israel and has chaired the advisory council of the bank. Together we

viii Preface

wrote volume 1, which deals with the monetary history of Israel during these

fifty years and beyond. This volume divides the fifty-year interval into three

main periods: from the establishment of the State of Israel in 1948 to the out￾break of the Yom Kippur War in 1973 (by Haim Barkai), the great inflation era

1973–85 (jointly by Haim Barkai and Nissan Liviatan), and developments from

the 1985 stabilization to the present day (by Nissan Liviatan). This volume

includes also an overview which was written jointly by the two authors.

We devoted volume 2 to the investigation of several important issues that

deserve additional clarification. Nathan Sussman performs an econometric

evaluation of the bank’s reaction function, Michael Michaely analyzes the

process of liberalizing Israel’s foreign-exchange market, Jacob Paroush surveys

the history of banking supervision in Israel, and Oved Yosha (who, to our deep

regret, died during the course of the project) outlined the research on compe￾tition and concentration in the banking sector. The actual research on this sub￾ject was carried out by his colleagues, Sharon Blei and Yishay Yafeh. Nachum

Gross reports on a series of interviews that he conducted with top officials of

the Bank of Israel, including governors, directors of the Research Department,

and other people in key positions (excluding incumbents). We take this oppor￾tunity to thank them all for their cooperation.

In this research project, we benefited from the insights and experience of

many people. Let us mention just a few: David Kochav, Eliezer Sheffer, Ephraim

Kleiman, Karnit Flug, Yossi Djivre, Ami Barnea, Yaacov Lavi, Gideon Shur, Meir

Sokoler, Zvi Eckstein, and Zvi Herkowitz. We also wish to thank the discussants

of an early version of the book at a conference that we held in December

2003—Assaf Razin, Michel Strawczynski, Alise Brezis, David Elkayam, Efraim

Sadka, Yoav Friedman, Dani Tsiddon, Rafi Melnick, Nadav Halevi, and Avi

Tiomkin—and the organizer of the conference, Sigi Tsur.

The Bank of Israel offered us all the assistance that we needed: free access to its

database and all technical help in research and processing of the data. We thank

our research assistants,Yevgenia Dechter and Asaf Nagar, who did an excellent job.

The book was originally written in English (except for the chapter by

Paroush) and then was translated into Hebrew for the Hebrew edition of the

book, which was published by the Bank of Israel in November 2004. This

required a tremendous effort on the part of the Publications Unit of the bank,

under the remarkable leadership of Moshe (Bari) Bar-Natan. In the prepara￾tion of the present revised edition, we benefited greatly from the excellent edit￾ing of Naftali Greenwood, who not only helped us with English language usage

but also helped in improving the clarity of the presentation in the text.

It goes without saying that all the views expressed in this book are those of the

authors; the Bank of Israel bears no responsibility for anything written in this

book. We wish to thank David Klein, Governor of the Bank of Israel as this book

was being prepared for publication, for granting us complete academic freedom.

It is with deep sorrow that I report the death of Professor Haim Barkai, my

coeditor and close friend, in May 2006.

Nissan Liviatan

Jerusalem

Contents

Tables and Figures xi

Overview 3

Part I The Formation and Development of

the Israeli Monetary System, 1948–73 23

1 Emergence of the Monetary Texture and Macroeconomic

Developments, 1948–54 25

2 The Establishment of the Bank of Israel: The Legal and

Institutional Framework of Israel’s Central Bank 58

3 Groping for and the Emergence of Monetary Policy,

1954–66 70

4 Monetary Policy in a Mobilized Economy 107

Part II Israel’s Great Inflation: 1973–85 139

5 Financial Repression 149

6 War and Oil Shock, October 1973–May 1977 152

7 The Liberalization Episode of 1977–79 159

8 Early Attempts at Stabilization 163

9 General Features of the Overall Inflationary Process 170

x Contents

Part III The Emergence of an Independent Monetary Policy and

Macroeconomic Developments after the 1985 Stabilization 195

10 The 1985 Stabilization Policy 203

11 The Consolidation of Moderate Inflation, 1985–90 208

12 The “Russian Immigration Wave” and

the New Inflation Step, 1990–94 213

13 Monetary Developments in the Second Half of the 1990s 217

14 The Real Economy Background 228

15 Moving toward Price Stability 230

16 General Features of the Disinflation Process 236

17 The International Perspective 262

Appendices 273

Notes 295

References 311

Index 319

xi

Tables and Figures

TABLES

I.1. Economic Indicators 1960–73 5

I.2. Economic Indicators 1974–84 9

I.3. Economic Indicators 1986–2002 15

1.1. Monetary Aggregates in the Mandate Period, 1927–47 26

1.2. Price Patterns, 1922–71 29

1.3. Main Items on Department of Issue Balance Sheet, 1948–54 35

1.4. The Fiscal Balance, 1948/49–1955/56 (ratio to GNP and

resources, percent) 36

1.5. Monetary Aggregates, 1949–54 40

1.6. GNP, Resources, and Employment, 1949–55 42

1.7. Prices and Exchange Rates, 1949–55 44

1.8. Measures of Nominal and Real Quantity of Money 45

3.1. Real Economy Indicators, 1954–67 71

3.2. Exchange Rates, Wages, and Prices, 1954–67 74

3.3. Real Exchange Rates and Real Wages, 1954–67 76

3.4. Monetary Aggregates, 1954–67 78

3.5. Banking System Aggregates 81

3.6. Liquidity Ratios, Money Multiplier, and Credit Ratios 82

3.7. Patterns of Selected Bank of Israel Asset and

Liability Balances, 1954–67 85

3.8. Selected Interest Rates, 1955–73 (percent) 91

3.9. Monetary Injections and Inflation (normalized by

monetary base at beginning of year, percent) 93

3.10. Unilateral Receipts and Private-Sector Net Conversions 94

3.11. General-Government Fiscal Indicators (percent of GDP) 99

4.1. Real Economic Indicators, 1966–74 108

4.2. Exchange Rates, Wages, and Prices, 1966–74 111

4.3. Real Exchange Rates, Real Wages, and Productivity, 1966–74 113

4.4. General-Government Fiscal Indicators, 1966–74

(percent of GDP) 115

4.5. Monetary Injections and Inflation, 1966–74, Normalized by

Monetary Base at the Beginning of the Year (percent) 117

4.6. Monetary Aggregates, 1966–74 120

4.7. Patterns of Selected Bank of Israel Asset and

Liability Balances: 1966–77 123

4.8. Unilateral Receipts and Private-Sector Net Conversions,

1966–74 126

4.9. Nominal and Real Interest Rates, 1964–74 (percent) 129

4.10. Banking System Aggregates, 1966–74 131

4.11. Liquidity Ratios, Money Multiplier, and Credit Ratios 137

II.1. Growth (% annual) and Employment 141

II.2. Fiscal Aggregates (percent GDP) 141

6.1. Selected Items of Public Expenditures (percent GDP) 153

6.2. Growth of Nominal Variables by Period (percent annual) 154

9.1. Real Resources and Uses 171

9.2. Monetary Injections, Inflation, and Deficit 188

9.3. Standard Deviations, Quarterly Data, Normalized by

Beginning-of-Period Monetary Base 190

9.4. Regressing BOI Injection (
CB) on Other Injections

(Quarterly Data), percent 193

III.1. Real Yield to Redemption on CPI-Indexed Bonds,

Fixed Gross Interest 200

12.1. Deficit and Total Expenditure of General Government,

1993–2003 (percent of GDP) 215

13.1. Indexes of Volatility 227

16.1. Difference among Measures of Inflation 238

16.2. Monetary Injections, Inflation, and Deficit 253

17.1. Inflation and Growth 263

17.2. Economic Indicators, OECD Groups and Israel 267

17.3. Monetary Contraction in Disinflation 270

17.4. Supplemental Data for Table 17.3 271

FIGURES

1.1. Monetary Aggregates in the Mandate Period, 1931–46 27

1.2. Price Patterns 1922–47 28

1.3. Monetary Aggregates, 1948–55 41

1.4. Prices, 1949–55 45

1.5. Pattern of the Real Quantity of Money, 1948–55 46

1.6. Excess Expenditure and Foreign Loans, 1948/49–1955/56

(ratio to GNP: percent) 50

3.1. Real GDP and Employment, 1954–67 72

xii Tables and Figures

3.2. Annual Inflation and Unemployment Rates (percent), 1954–67 72

3.3. Monetary Aggregates, 1954–67 77

3.4. Prices and Exchange Rates, 1954–67 86

3.5. Exchange Rates and Prices, Annual Rates of Change

(percent), 1954–67 86

3.6. Government and BOI Injections 100

3.7. BOI Injection and Private Conversion 100

3.8. BOI Injection and Private Conversion Government Injection 101

3.9. Money Multiplier, 1955–66 104

4.1. Real Aggregates—GNP, Employment, and Import Surplus,

1966–74 109

4.2. Inflation and Unemployment Rates (percent), 1966–73 110

4.3. BOI Injection and Private Conversion, 1966–74 117

4.4. Prices and Exchange Rate, 1966–73, Annual Rate of

Change (percent) 118

4.5. Monetary Aggregates, 1966–74 119

4.6. Monetary Aggregates, 1966–74 (rates of change, percent) 119

4.7. BOI and Government Injections, 1966–74 (percent) 124

4.8. BOI and Private Conversion + Government Injection, 1966–74 136

4.9. Time Pattern of the Money Multiplier 136

II.1. Monthly inflation in Israel, Q1 : 1964–Q4 : 1996 139

II.2. Real Business-Sector Wages and Labor Productivity 141

II.3. Unemployment Rate (percent) 142

II.4. Total General-Government Deficit (percent of GDP), 1960–2003 143

II.5. National Debt Relative to GDP (percent) 143

II.6. Gross National Saving Rate and Division between

Private Sector and General Government 144

II.7. Total General-Government Expenditure and

Defense Expenditure (percent of GDP), 1960–2003 144

II.8. Real Interest Rates (Average cost of credit and real yield on

government bonds) 145

II.9. Real Interest Rates on Loans and Deposits (quarterly data),

Four-Quarter Moving Average 145

II.10. National Saving, Domestic Investment, and

the Current Account (percent of total income), 1964–99 146

II.11. GDP, Year-on-Year Volume Change (percent) 147

6.1. Changes in Credit/GDP Ratio (percent) 154

6.2. Real Exchange-Rate Measures (real depreciation—up),

Index 155

7.1. Ratio of Directed Credit to Total Bank Credit to Public 162

8.1. Net Inflation Tax (percent of GDP) 164

9.1. Ratios of Monetary Aggregates to GDP 177

9.2. Civilian Import Surplus (percent of national income from all

sources) and Annual Inflation (within years) in Monthly Terms 184

9.3. Rates of Change: Controlled Prices, Import Prices, and CPI 185

Tables and Figures xiii

9.4. Import Surplus, Total General-Government Deficit, Seigniorage,

and Inflation Tax (1970–84) 185

9.5. Government and BOI Injections, Percent of beginning of

quarter monetary base. Four-quarter moving average 191

9.6. BOI Injections and Private Conversion, Percent of beginning of

quarter monetary base. Four-quarter moving average 191

9.7. BOI Injections and Private Conversion plus Government

Injection, Percent of beginning of quarter monetary base.

Moving average of four quarters 192

III.1. Economic Indicators, 1990–2004 199

10.1. Measures of the Real Exchange Rate, 1980–2004 206

11.1. Fiscal Impulse as Percentage of Potential GNP 212

12.1. Rates of Change: CPI, Currency Basket Exchange Rate, Prices of

Controlled Products, and Nominal Wages (percent annual) 216

13.1. Inflation and the BOI Interest Rate, 1990–2004 221

13.2. Spread of Short-Term Nominal Interest Rates on Assets, With

and Without Devaluation Expectations 222

13.3. Real Spread on Assets Ex Post 222

13.4. NIS-Currency Basket Exchange Rate 223

13.5. Monetary Base, Foreign Reserves, and Net Domestic Credit

(percent of GDP) 223

13.6. Loans Denominated in Foreign Currency (or Indexed Thereto)

in Total Bank Loans and NIS-Denominated Assets 224

13.7. Long-Term Activity in Foreign Exchange:

Sales()/Purchases(), Cumulative-12 months 224

13.8. Sovereign Spread (Israel and Emerging Markets) 225

15.1. Inflation Expectations, CPI, and Inflation Target 231

15.2. BOI-Fed Interest-Rate Spread 231

15.3. Yield Curve on Unindexed Bonds, December 2000–July 2003 233

15.4. Yield Curve on CPI-Indexed Bonds, December 2000–July 2003 233

16.1. Taylor Rule and the Interest Rate of the BOI 244

16.2. Import Surplus, Total General-Government Deficit,

Seigniorage, and Inflation Tax 250

17.1. Relative Per Capita GDP 264

17.2. Inflation and Real Interest Rate 268

E1. Inflation and Money Substitutes (X) 284

xiv Tables and Figures