Academic journal article Journal of Money, Credit & Banking

On the Fit of a Neoclassical Monetary Model in High Inflation: Israel 1972-1990

Academic journal article Journal of Money, Credit & Banking

On the Fit of a Neoclassical Monetary Model in High Inflation: Israel 1972-1990

Article excerpt

This paper uses a money-in-the-utility model to show that the Israeli data from the high-inflation and poststabilization period fit well the predictions of a simple, neoclassical framework. Specifically, a single parameter money demand equation that is derived from the model fits the data much better than a Cagan money demand function. The model's implication on the inflation-seigniorage relationship is consistent with the observed fact that while inflation was rising, the inflation-tax revenue remained almost trendless. The labor supply equation derived from the same model is remarkably consistent with the real wage and employment data over the high inflation and stabilization period. There is no evidence for the existence of a Phillips curve" employment-inflation trade-off. After the stabilization the demand for money seems to shift. This phenomenon may be due to improvements in transaction technologies as well as to expecations for stabilization during the high inflation. We also show that temporary fixed exchange rate-based stabilization and "consumption boom" in the poststabilization period imply low levels of inflation that are consistent with the model.

This paper uses a money-in-the-utility model (Sidrauski 1969) to show that the Israeli data from the high-inflation (1979-1985) and post-stabilization period (1985-1990) fit well the predictions of a simple, neoclassical framework. Specifically, a single-parameter money demand equation that is derived from the model fits the data much better than a Cagan money demand function. The latter does not fit well low- and high-inflation periods at the same time, and therefore, may erroneously indicate that money demand is not stable. The model's implication on the inflation-seigniorage relationship is consistent with the observed fact that while inflation was rising, the inflation-tax revenue remained almost trendless. This result contradicts the Cagan-type money demand implication of being on the "wrong side of the Laffer curve." The labor supply equation derived from the same model is remarkably consistent with the real wage and employment data over the high inflation and stabilization period. There is no evidence for the existence of a "Phillips curve" employment-inflation trade-off.

The congruity of the evidence with a neoclassical monetary model suggests that the policy implications of the model are to be taken seriously. In particular, (i) in order to stabilize inflation it suffices to set the expected present value of the government budget deficit (including the central bank) to zero. (ii) There is an immediate welfare gain associated with the stabilization which is estimated to be in excess of 5 percent of GDP in the Israeli case. (iii) There is no evidence to support the view that stabilization is associated with a loss of output (due to increased unemployment) as would be implied by a Phillips curve.

After the stabilization the model overpredicts the demand for money. This phenomenon has been observed for other dis-inflations and may be due to improvements in transactions technology as well as to expectations for stabilization during the high inflation. Temporary fixed exchange rate-based stabilization, "consumption boom," and low inflation in the poststabilization period are also consistent with the model.

The consistency of the Israeli data with the neoclassical monetary model strengthens the view presented in Sargent's (1986) classical paper, "The End of Four Big Inflations." There Sargent argues that under rational expectations, with credible stabilization programs, a rapid reduction of inflation rates has very small real costs (if any). Some increases in unemployment rates can be traced to the disruption of economic activity during the final phases of the rapid inflation, or to political events, but not to the stabilization per se.(1)

The fact that seigniorage is not increasing during the acceleration of inflation is common to all inflationary episodes [see Bental and Eckstein (1990) and the literature cited there]. …

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