The Bank of Israel - Vol. 1

By Haim Barkai; Nissan Liviatan | Go to book overview

Appendix E: The Paradox of Indexed
Money Substitutes

It has been a widely accepted view among economists that inflationary finance can be helped by reducing the substitutability between money and other financial assets. This is the rationale for imposing financial repression, which prohibits the holding of foreign exchange and other money substitutes (Nichols, 1974). Empirical evidence about the positive effect of financial repression on the demand for money in the 1960s is presented in Fry (1988, p. 15).

Developments in chronic-inflation economies in the 1970s, however, point to the opposite pattern of behavior. Specifically, a universal feature of government behavior was to introduce indexed money substitutes despite the implied damage to the inflation tax. Thus, in 1977 the government of Israel introduced dollar-indexed deposits, which dominated broad money. Similar developments took place in Latin America (Galbis, 1979). By so doing, the government shot itself in the foot. The explanation of this paradoxical behavior is the subject of this appendix.1

The explanation is based on the distinction between discretion and rules. In the discretionary regimes that were characteristic of the chronic-inflation economies in the 1970s, the loss of credibility in monetary policies forced governments to regard inflation as being partly exogenous. In this case, the government felt that it had to “protect” the economy against the harmful effects of inflation on domestic liquidity, even at the cost of a loss in revenues. This was the rationale for introducing indexed money on a large scale. Under a rules regime, the behavior is quite different.

Suppose we have two types of money—h, representing conventional real money balances, and x, representing indexed money substitutes. Assume a

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