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The Current Recession and Steps Required for Sustained Recovery and Growth Richard Ablin Discussion Paper 91.08 May 1991 Any views expressed in the Discussion Paper series are those of the author and do not necessarily reflect those of the Bank of Israel . Research Department, Bank of Israel, POB 780. Jerusalem 91007, Israel Abstract article presents The recession" from late 1987 analytical discussion of the Israeli "growth an to early 1990, and of the implicit steps needed for It identifies (with the help of the ISLM paradigm and supplementary data) the primary source of this recession as the strong trend of recovery and sustained growth. erosion of the real exchange rate from 1985/86 to late 1988 (itself the result of the use of the nominal exchange rate as a relative "anchor" disinflation, in a situation of inflationary inertia and nominal monetary expansion essentially adapted to nominal A for the purpose of GDP rather than the nominal exchange rate). secondary source appears to have been a weakening of investment propensities incident upon debt problems related (in large part) to an extraordinary surge of ex post real interest rates in the year of radical disinflation (1985/86). situation at the start of The 1990 correction (rise) of the real exchange rate, therefore called for a significant together with growth in real money balances consistent with cyclical recovery and later potential growth. 1990 however saw the start of the great wave of Soviet Aliyah. An appraisal of this change that it involves several factors tending to shift the equilibrium real (at full employment) in both rise in capital imports, directions. which Among would lower exchange shows rate these however, the (probable) massive this rate, is likely to predominate (tending to offset the previously required rise). The greater uncertainty on this score suggests that recovery policy should center initially monetary expansion consistent with the "recovery" growth upon a rate of real rate of domestic demand, while adopting a "wait and see" approach to the need for real devaluation. The progress of disinflation (the object of the pre1989 exchange rate policy) is also analyzed, together with further examination of the need and formula for price shock deletion from wage linkage in the event of devaluation. Current Recession and Steps Required for Sustained Recovery and Growth The R. Ablin April Forward; This article 1991 constitutes, for the most part, a macroeconomic analysis of the situation at the end of 1989, following two years of growth recession; of the impact on that situation of the great Aliyah wave which began in 1990, and of the steps needed to achieve cyclical recovery, as well as sustained growth at the rising potential rate. Before turning to this however, a few words of background and of "moral homily" are in order. In November 1989 the Bank and the Finance Ministry were in the process of preparing policies for some rise in growth in updated to reflect the rapid rise 1990 and beyond (successively in anticipated Aliyahj the latest taken into account here in July 1990). This constituted however, stage a belated response to the extremely costly growth recession which had already afflicted the economy and the nation since the third quarter of 1987 (i.e. a as of late a rise of 1989, of at least "U" from 6 social affliction was to 10*). 7* or over He NIS GDP "gap", 5.0 billion in 1989 prices, and should do this in keen awareness that this neither officially foreseen and prevented, or attacked with all possible dispatch, by the authorities responsible for macroeconomic policy. Moreover, this tardiness was once again not free of the taint of using recession as a preferred (rather than less importance than full employment "no choice") means of achieving goals of GDP. Coincidentally with the first draft of this paper. o Measured U rose to a 9.3* high in the second quarter of 1989; but available data ("Recent Economic Developments," Bank of Israel, June 1990) shows that it would have reached 11* or more in the next three quartersr if not for an obviously responsive rise in government employment (by 33,000 or 2.3* of total employment). The figure of 10. IX was reported for the second quarter of 1990. 2 Thai National > lie recession Vu'lgots ■. 1 J/3H7 was not foreseen is nnd 1988 (and latter, published as late as January 1988, the forecasts of the shown by related statements). by many forecast The growth of 3.7tf in 1988 GDP )4.6 £ for the Business Sector).3 irony of this situation is that such a recession was entirely The foreseeable (and was conditionally foreseen) Jf policy makers failed to prevent a prolonged erosion of the real exchange rate still incomplete disinflation of designed the 1985. (ER_), following the after having specifically Yet "heterodox" freeze of the Emergency Program to avoid the usual transitional recession, normal to the process of orthodox disinflation, r.he authorities (for whatever reasons) permitted the economy to sink directly into such a recession in 19871989. The much heralded recovery of growth following transition from the Emergency Program, which indeed began in basis of the relatively high quarter of of 1987 1987, was brought to ERr a levels prevailing no from 1985 to the on the first definitive halt already in the third quarter (note: before the onset of the Intifada). been allowed to erode by mid 1986 less than 20/6 from The real exchange rate had its average 1985 level to the fourth quarter of 1988. Actual growth rates were 1.6 and 1,ltf respectively. The error was concentrated mainly in a projected growth of 5$. in exports (g+s ) which more or less ignored the impact of the long and steep erosion ofER (See appendix on both this point, and on the potential effects of Y and £J£. on the import surplus (g+s) during cyclical recovery.) . I.e. allowed continuation of the "RelativeInflation Fixed ER as I termed it in several papers leading up to "The Present Inflation Growth Predicament in Israel", Economic Quarterly, (in Hebrew), December, 1987. This syndrome (whatever called) is generally recogni2ed in recent literature. Apart from s tandard texts (e. g. Dornbusch 1978 and later editions), see recent applications by Liviatan (1988) and (in analysis of the "Walters critique" of the EMS) M. Miller and A. Sutherland (1990). Further evidence is offered by country studies assembled in Harberger (1984). Syndrome," 3 Policy adjustments were finally undertaken in 1989, reversing for l/6th of that decline (a fourth of the erosion year as a whole only about since 1986), but more the importantly quietly shifting to a policy of stabilizing the ERr (by a combination of an upward trend of announced bands and of changes in the ERn adjustments within central rates at required intervals) . This alarming record (especially up to the end of 1988) should not induce despair, but it should inspire a degree of humility in the course of our present and future efforts. In particular reject, the reversal of ends should understand clearly, we and involved in choosing recession over and means directly applicable, and far less costly instruments, such as devaluation incomes policy, controlling the for external balance or and achieving disinflation. The Onset of the Present Recession )1) The fallback of actual of 1987 through 1988 and 1989 GDP(Y) from potential GDP(Y^, from the second half is broadly consistent (although precise quantification is difficult) with the "multiplied" impact of the fall in "net exports" (exports imports or of Y NX) atY_ . NX from IL was at least ^ momentum at Yp fell 3 or 4X. (We by about 2 to 2cfX of GDP in 1988. The shortfall consider thesenuarbers in more detail below.) discuss (in the final section) a new tendency, during 1990, toward an "upcreep" of the trend ERj. . We gathering some We should also resist the temptation to gloss over our policy failure in view of the similar performance by many other (by no means all) In fact, this "traditional" approach has long been used with greater restraint in the most advanced (i.e. public welfare oriented) democracies, such as Sweden and the U.S. and, in effect, rejected during most governments. much , of the last decade. easily obtain reasonable consistency with this appraisal if we the range suggested by statistical work in this area. (See appendix 1, especially Table 1, footnote 3.) These imply an '88 rise of M^+s 2.5* of GDP (with a further rise in '89) due to '86 to '88 We apply "ER^" ERj. erosion. elasticities in k (2) This broad result of a shock to (EIL ). But (DD) , fact implies that the recession NX arising it also implies that the policy factors affecting domestic NX policy), have been relatively tight in the sense that offset the negative multiplier effect upon "NX = 0" its 1986 Y The Y . equilibrium (for example, the reader Dornbusch and may Fischer's 1988)9 a , demand )e.g. monetary they did not tend to and Y. aid of the wellknown an initial (that is, the current account is in equilibrium; to the last quarter of Q shock implies, in figure 1, be considered desirable net capital imports) at from of case to The position in which X = DD can strengthen this verbal description with the model. ISLM first of all, erosion of the real exchange rate from the apart from its multiplier equilibration to the We was, M The effect of a long erosion of 1UX decline from the average level would be to shift the NX = 0 ERr line to refer to such a standard (but excellent) text as Macroeconomics, (e.g. p. 608610, 1978 edition). To slightly simplify the discussion of the text, "r" is substituted for "i" in Figure 1. This merely allows us to avoid one or two formal steps to arrive at essentially the same result. As Dornbusch and Fischer point out (p. 588) the assumption of fixed P (and zero n) in the presentation of the ISLM diagram is made merely "to develop the details of the analysis most simply" (i.e. most clearly for pedagogical purposes). D S F themselves show the effect of the relaxed assumption (variable P and n) only in connection with the "Y Ys" diagram. It is in this latter diagram incidentally, that the "NX = 0" curve assumes a negative slope because it is shown against P, not i or r. In the ISLM diagram "NX = 0" is vertical (I.e. the level of GDP at which external balance is achieved is a function of the ERj. and hence of P, given ERn but not of i or r.) IS and LM may be shown against " i " by adding an n premium on the vertical axis for steady or expected n. It would then be necessary to show any shifts in IS or LM (due to AM3, AER etc.) as consisting of both a horizontal real shift, and a vertical nominal shift for An. Since we are here concentrating upon explaining the real changes, it is simplest to show IS and LM against the vertical interest rate axis deflated for P, keeping in mind that policies which shift these curves (e.g. a + AE^, stimulating a rightward shift in NX = 0 and in the IS curve) may also have some effect upon 71. (We consider the latter effect elsewhere.) , ; , a This measures ERr according to on a monthly basis(. available the relative WPI price index (which is the left (NX = It 02). would then require a fall from to Y Y3 to restore צא equilibrium. )3) The drop in NX at implies a drop in aggregate expenditure (total Y uses); which brings about a leftward shift of the IS curve. shows The the combinations of extent of this shift (Y Y and r at Y2) which both expenditure indicates the drop in these equalities (i.e. the size of the multiplier). It than the shift reduced S, as and expenditure of NX = Y = [The Y IS curve I and = S. ] required to restore is somewhat smaller 0, because part of reduced expenditure 'leaks' well as into a reduction of imports. Hence, the equality into of is reached before wiping out the entire increase in the Y NX deficit. 10 ^>)א Fiqure ftX*o, 1 .1 t More formally stated, the difference of the leftward shift of NX = 0 tbat of IS is caused by the fact that the NX = 0 multiplier (i.e. the fall in Y needed to cut the NX deficit back at its original level) depends only upon the "marginal propensity to import," while the IS (Y) multiplier depends upon this plus the marginal propensity to save. The size of this difference in a small economy such as Israel, is greatly reduced, however, by the fact that imports (and MPM) are large relative to MPS. Quite possibly, therefore the Y multiplier may equal 3/4ths, or more, of the NX = 0 shift. 10 from 6 (O by the The fall shift of in would then be Y IS along an unchanged further dampened (to curve LM Yj (i.e. implying rather than Y2) decline in some r and consequent rise in I). If the situation is as )5) )approximate) fall of that some additional the recession of all the Y new way to the ISLM , the is portrayed position in 1988 implies shock must have added to NX by a leftward intersection at greater leftward shift of LM This is Y2. (r NX = would have a generally downward course, shift of ( to LM ^) LM closer to, but reduced Y IS still further, but would we know that r was in there is a greater likelihood of additional factor increasing the original 1 . also have raised r above its original level. Since on 0 NX = then the observed possible candidate; an "accommodative" (or pro Y. One slightly above the level corresponding to A new factor or factors besides cyclical) reduction inM producing a postulated here, shift. And, indeed, fact some examination of investment behaviour suggests that such a factor was present; namely, that the shock to NX given r). Y and wave, which was was supplemented by a shock to the propensity to invest (I at This would have been a probable outcome of the "bad debt" also moving towards its crescendo in 1988. the growth rate of I in fixed assets was The collapse in similar to that in export growth )although only about half as large in absolute terms). Such a further source of IS shift (to IS 3) suitably brings us to a Such a procyclical shift of M5 (detailed below), was, indeed, contrary to most past behaviour. (E.g., in reaction to the "mitun" of the 1960s, in which Mlj. (during yr) rose from 2X in 1966 to 193i average in 1967 and 1968; or to the 1953 recession, in which Mlr rose from 12tf in 1952 to 2Di in 1953.) See Figure I crisis in 2 below. have discussed the predominantly temporary character of "High Interest Rates, Spreads and Margins in Israel", Israel Discussion Paper, July 1990). this debt (Bank of 7 position in general agreement with the observed facts; a drop in Y(to VjJ sufficient to preserve the balance of the previous year, and some reduction NX in r (to r3).13 One might, indeed, formulate slightly different scenario consistent some with the broad facts cited, but the basic thrust of the explanation would be similar that the recession which includes demand, generated by shocks to was predominantly NX), and (GDP Y*^ that monetary policy (and domestic demand policy in general) permitted the multiplier effects of these shocks to themselves out in a. reduction of Y more or less sufficient to work stabilize NX.1A The Actual Figures in We the may money policy. We M supplement Growth the above analysis with a look at the actual behaviour of aggregates with a view to evaluating "revealed" (or de facto) monetary first show that the trend of wide recessionary real rates, following an initial show growth rates for nominal Ml, M2 and M3 M growth (M3) went surge in late for a recent steadily 1986 and 1987. 12 month down to We then period (August October 1988 to AugustOctober 1989) in the midst of the recession.. This is also consistent with the rough quantification of our original stylized facts: A fall of NX at Yp of 2* of GDP, divided by a MPM + MPS of about .7 or .8, would yield a "multiplied" short fall of Y of about 2. 5tf. The actual shortfall was larger (up to 4XJ; leaving room for the effect of the other recessionary factors. that fiscal policy was also essentially passive in both 1988 and fiscal deficit at Yp (full employment) was kept approximately constant, although the actual deficit was allowed to rise with the cyclical slowdown in tax revenue, etc. (This is pointed out, inter alia, in the Public Sector chapters of Bank of Israel Annual Reports.) Note 1989, that is,the . Year August October'88 M3r CPI 1 '89 (year to year percent change( 1987 33 20 1988 19 16 1989 17 20 standard. The negative relatively higher rate of Ml demand 12 5% . = ■ M.3% (i.e. potential TL later period has been at least 26^ the 21.'0* = K K n, Since the growth rate of nominal in K +m GDP plus inflation) rates are low by any these is apparently the reflection of the Ml relation to the real interest rate (r); which was declining during the first half of this period. This factor tended to shift funds within M2 and toward Ml. But even with this boost; ML did not get M3 * of nominal The term nominal (relative to Y (consistent with a constant r) of all 2696 more than real interest) still and fell is not necessarily inconsistent with this evaluation. With a stable equation, the fall in from or ahead (while the others fell well below it). fact that "r" (short somewhat M Y_ up to to 20"^). Nominal Ms Y M (essentially ) would M3S) was apparently reduced by even on r was more than offset by the shock to the I propensity, "arm twisting") which were also tending to reduce r To sum rate (e.g. aggregates "proportionately" this, but the potential positive effect other factors (e.g. reduce the growth . up; whatever the precise truth, policy did not act in a countercyclical way it is at least certain in 1988 and 1989 to that M3 offset the recessionary process (the original shocks or the multiplier). Although interest rates down went down somewhat, further to do this (i.e. the it LM was curve clearly necessary for in figure 1 would them to go have to shift rightward beyond its original position simultaneous correction right); this of the would have meant EIL, a Y of LM^). erosion (shifting recovery at course, Of NX = 0 without a back to the expense of a larger the NX deficit. Even this would not have been intolerable however, given our foreign currency reserve position during 1988 and 1989; at least, as a short terar expedient to achieve support this recovery On radical 3 was being more the well known premise contrast Israel's at best, recovery while the adequacy of the exchange rate to two on that "one picture is worth 1,000 words," the between unambiguous earlier recessions (in the accommodative policy in for data carefully evaluated. M, " 1989[. shown in Figure 2. (See Appendix and on the shorter duration of the earlier recessions.) 2 failure of MS to move in this direction was a departure is also reflected in recent statistical results [Tal and That norm monetary policy in '50s and 160s), and procyclical or, this one, is Figure past countercyclical from the Elkayam, 10 .Developments in 1989 low Y) During 1989, continued at about the 1988 level; additional rise of the (implying, of course, a large contrast This Gap). GDP (i.e rose, while the growth recession NX to 1988 can be easily understood in the light of our previous analysis. It reflects the fact that, in 1989, there NX effect further decline of was no of the continued fall from 1986 to the tending to balance the positive relative Y a partial correction was finally noted, made to Y in the On . ERj. the contrary, as (~ /tif of Y was now the decline fourth quarter of 1988). With the leftward shift of (relative to more of ERr Y_) 0 NX = slowed or stopped, than necessary merely to keep Diagram 1, the ISLM intersection now NX falling by constant. (In terms of occurred to the left of the new NX = 0 line). The Y question remains of what caused the continuing fall of (i.e. in 1989 There can be the continuation of little Y ~ X.2% doubt that lags are involved in a change (e.g. fall) in least quarter) and this effect widens over 23 one years). initiating The NX = ERr this outcome. For example, 0" with a .lag (at affect only begins to a 0 shift "NX = considerable period (possibly also requires time. relative to Y slight signs of and improvement. Y_ relative to of, say, S.5%). Y Multiplier process (then induced) itself continuing decline in showing versus a Y This lags behind the could explain a in 1989, even while Nor should we NX is already forget the other factors )discussed above) which were involved in initiating the recession (a fall in the I propensity and tightening M ) . The effects of these also occur over a distributed lag. The a size of the NX = 0 shift, relatively larger contribution and the was made Y shortfall in 1988, suggest that to the continuing growth recession 11 in 1989 by the non "NX" (i.e factors. nonERj. ) suggest a gradual continued decline of As noted above , the numbers into 1989, and it also quite ifr possible that the weakening of the investment propensity may have hit bottom only in this year. In sum, this analysis suggests include lower )1990), we DD and higher NX how a still than in 1988, recessionary and that, Y in 1989 might in the next stage should expect to observe a return toward the potential growth rate although certainly not the closing of a major portion of the )Y ) , GDP level gap.17 How Much n Had We Been Squeezed Out and How Much Remained (by the have thus start of 1990) persisted through 19881989 (at the high cost described) in effort to complete our disinflation by orthodox means; first holding both ERn and J£. and latterly only /af, below the existing rate of inflation. What an has been our success so far? The answer is, first of all, that our experience )since 1985) has added to the abundant international evidence of the inertia of n) with respect to cyclical fluctuations in real growth. Israeli rise during the surge of growth in 198687, and it has fallen /r did not by only a noted before, the declining trend of short term r, despite falling reflect the exceptional slump in I demand. Theoretically, the latter is partly "cyclical" (reflecting a relation of I to Y and expected Y) and partly "exogenous" (i.e. a fall in the I propensity apart from Y). In reality, these two factors in I determination are difficult to separate; and social psychology suggests that they interact. In any case the I propensity is likely to slump further (and over a longer period) if the authorities give no sign of a serious countercyclical policy reaction (a description which, as we have seen, corresponds to the stance of Israeli macroeconomic policy in both As M_, might largely 1988 and 1989). Preliminary estimates in late 1990 tend to confirm this expectation. 12 fraction (its "ERr corrected" rate, that is) during the long growth recession of 19881989. One way of to see this is summarized in Figure 3, showing the actual rates inflation, versusj (a) these rates WPI of actual devaluations; impacts (b) excluding the 1 for the adjusted 'normal' Plevel total of same devaluation, but carried out in a "smooth" manner; (c) adjusted for the extent its of devaluation which would have kept ESr approximately stable at level, and reduce the The adjusted for the (saaller) extent of devaluation needed to (d). decline from EBj, 1985 to 1989 from about 20& finally 1986, the recession of 19881989 (by perhaps 4 managed us (at the start of level of about "Sal") of 16& underlying fall versus [1990 45X1 1990) with an OECD a Y titne since to cut the "underlying" percentage points). estimates described above as nearest to the left to about 10^. results of this exercise suggest that, for the first during 1989 1985 taking even the (d) But equilibrium of "true" (i.e. WPI £R EKj, , this still corrected) inflation level (or level in the countries of the figures to June support the conclusion of an in n, and suggest de facto policy of stable ER^. a further decline. fell to an The WPI annual with the rate of only new 11&. Ironically, this trend has been obscured once again in the public view (which 0 concentrates upon the CPI); this time by the housing prices. Even this * Aliyah related surge in ] fractional cut in excess Israeli inflation (about l/3rd), has are not included in the WPI, which is based on goods^. " The CPI, excluding housing prices, significantly the WPI. It is true that in a perfectly flexible price economy; a Housing prices "industrial new fell, in line with surge in one relative price, even as weighty as housing, "should" not raise the overall P level. In the real world it undoubtedly does (especially in the short run); but the "net of housing price" rises (both CPI and WPI) probably do somewhat overstate the true drop in underlying n. 13 Figure 3: Analysis of Wholesale Price (WPI) Inflation, 19861989 \ **\\ to eM0t 91 C*' ifct<Jm,\ £.81 .ift'/ ,, . .<7.oyi ro +*** V9? )b) C f Etf,. Ml shock. ■x. .£ ' '9$ 'It (2) . WPI )Dec. Dec.) ER" (Sal) )Dec. Dec. ) (3) 'Normal1 P Shock ( (D(3) (4) (5) Corrected (O WPI excl. )3) V 1986 15.1 6.5 3.2 11.9 11.5 1987 20.9 14.2 7.1 13.8 12.8 1988 15.8 1.3 0.6 15.2 15.1 21.5 20.0 10.0 11.5 10.4 1989 * *i0yi)(t\) יExtrapolated from first eight months; assuming same changes as in 1988 during the rest of year. ER" assumes no change after August. [Note that these estimates were carried out in OctoberNovember 1989. The final 1989 figure for WPI (19.5^ suggest a somewhat further advance in disinflation then this estimate. ] This would imply a similar downward correction of the several "ER adjusted" 1989 rates in the above diagram (e.g. rate "d" to about 16.5*). 14 as at the price of at least 2.5 years of growth have seen, been purchased we recession. the On covintry the hand, this is strong evidence against imposing on one immense additional cost of getting all the 71 levels by further pursuit of the "orthodox" route. implies that, convert it if we welcome into a true cyclical ■. by 1990: Entry of the Soviet Aliyah recovery, 1989; have to freeze program) a second forego further but need not be Wave that is, the eve of the found a cyclical recession, a Y gap new wave of at least of Soviet 7^, and a U of in excess of the (relatively high) base position of 1987. To the (large) extent to which the recession had been due to the erosion FJ^. (i.e. the continued uptrend of rate of nominal devaluation), )1) we may 43> about of We the other hand, it far concentrated upon the definition of our macroeconomic position as of the end of Aliyah. OECD the prospect of a serious rise in inflation. 18 frightened off have so to the prospective growth recovery and wish to disinflation (in the absence of We On way down the the ideal P and f^ way against a policy restrained to deal with the problem was to; reverse the accumulated erosion of ERr by devaluation (with, of course, proper deletion from resulting onetime P W linkage), (2) provide monetary accommodation for effect and for the positive impact on NX the together with The inertia of 71, as noted above, works in both directions. The sharp boost of growth from 19851986 to 19861987 (from 3.2 to 7.8cf) or its reflection in 1987 as a whole, failed to raise 71, and this started from a position closer to full employment than the present one. In both of the two earlier Israeli recessions (reflected in Figure 2)j strong cyclical recovery over one or two years hardly budged 71. Internationally as well, cyclical )including employment) recoveries (which have proceeded more from stimuli to demand, deliberate or "accidental," than from the market induced fall in Wr) have had only moderate temporary effects on P. (See, inter alia, Summers )1990) and Appendix 3 below.) 15 the subsequent multiplier adjustment of the stabilisation of the ERr policy makers had 1 stabilization. ER^ (3) choose between combining shifted indeed n trend (at least, through repeated small devaluations. clear in the course of became Y, with the completion of disinflation by means of a temporarily) and stabilizing It and or accepting the existing freeze, second temporary DD early 1990, 1989 and ade to facto that Israeli policy of EKj. g In this section we shall not attempt to appraise recent estimates of the it is large (as in July 1990 Bank projections), to determine qualitatively whether, and if so, in what manner, this major new Aliyah wave, but, assuming development alters the appropriate policy for the recovery of macroeconomic equilibrium. can approach the We 4 below) to the analytical problem most simply by returning (in fig. ISLM paradigm concluded that the of Figure 1. In our earlier discussion, recession was, in all probability, not only the result of the erosion of ERj. (shifting the current account equilibrium the left of ), but also of one or more shocks to Y we DD "NX = 0" line to independent of this disturbance. The entry of the Aliyah context (although financing capital imports may wave much per se has three basic effects in this of the complementary investment wave by alter the outcome as the existing "rules of the game," this wave of effective domestic necessarily raises i Y_, and we shall see below). (1) Because of human wave demand (DD). (2) With a is translated into a rising slight lag, the surge in the resulting rise in L/K quite possibly raises the Signs of a further shift to a de facto policy of "upcreep" in the evident in mid1990. (See "Afterward" below.) became more Ls ER 16 Y_ equilibrium level of ER_ (3) Because of the as well.20 "I" component of this additional expeaditure business investment in general), iarportoriented than in DD we may assume general. (housing, infrastructure and that the addition to This amounts "compositional" change affecting the import surplus The ERy at to (i.e. at a itself such a compositional (or import intensity) effect equilibrium disproportionate DD is more a temporary given would also ERj. ). By raise the Y_ . Effects of Alternative Sources of Finance: If we assume that only the increase in the import surplus induced (at the given level of ERy) by the compositional factor will be financed by an increase in capital imports, then, )abstracting froa the possibleL/K effects noted above), the shortfall of the "NX = 0" line from its proper by the coopositional effect), which The rise inL is The broad effect possibility curve) with a position would remain unchanged.21 import surplus at regard as the "equilibrium" before the Aliyah wave, TL we amount would Y now be What we larger than of additional net ioports (i.e. the finance by additional capital imports. a rise in of this L/K as well, even if spread over. several Yp (i.e. the production bias toward nontradables (NT). This follows from the higher labor intensity of NT, and implies a rise in the equilibrium level ofPT/Pw.jr. (i.e. in ERj.) atY^ . On the other hand, the differing character of the new L (more human capital), will probably oppose this broad or neutral effect, since it is likely to somewhat favor tradables. The broad effect is especially likely to predominate in the first few years. (Appendix 5 provides a diagrammatic view of this question.) years . . is to raise Note that, even in this case, the assumed increase of foreign capital has an effect in the capital market, as well as in the foreign currency ararket. It provides a substitute for an increase in domestic S which would otherwise be needed to cover this portion of the increase in "I". However, because this increase in capital iarport just balances the increase in demand for imports (i.e. in "T") which this Ioriented program. of increased DD is assumed to cause , it neutralizes the need for a shift in the economy's position on the production possibility curve (i.e. relative output of T and HT) and, hence, in the equilibrium PT/P"T (= ERr) . With no increase in capital import, ER would have to risej and with a greater increase (see below), to fall. 17 Finally however, the more optimal case in which a must consider we greater increase in capital import is induced by the rise in from the Aliyah wave. L/K resulting latter raises the marginal productivity of The )physical) capital in the country, and, (in the absence of capital import), the real interest rate saving. as well, the limited elasticity due to of domestic this financial resource can only be used directly for net Since importsj i.e. for tradeables, its optimal exploitation requires some shift of the economy's equilibirum resources toward nontradables, and thus, a reduction in the own ERj. at (at least during the course of the Aliyah program). Y )See appendix 5, for a diagrammatic Returning first to essentially unchanged, constitutes a DD in Figure 4) in the direction of The by ER^ at K remains find that the surge in "I" linked to the Aliyah "shock" which must implications of this clarification of this case.) the case in which the equilibrium we willynilly push the a useful exercise, As Yp economy wave (the IS curve we may clarify the considering three possible cases: positive shock to IS may approximately equal, fall short of, )quite probably as expected Aliyah rises) exceed the earlier negative shocks which supplemented the shock to the first IS at the position to case (equality) in Figure which it was In this case, the correct rise of backto 00 Y_), t\t\ NX 4 arising by a shift from ER_ erosion. will also suffice to shift (i.e. the rise DD picture I S3 to IS2. This leaves from driven by the effect of ERj, We or which IS2 back to ISj , ERj. erosion alone . will shift intersecting NX = LM 0 at It should be kept in mind that the stimulus for this large capital import is temporary subsiding with the recovery of "normal" K/L ratios. Furtherj the equilibrium level of external debt and, hence, capital service payments to the rest of the world, will be permanently higher following this period, requiring (cateris paribus) a somewhat higher equilibrium ERr at Y than prior to the rise in capital imports. n Figure 'v*a0rf.* 1987 (2) IS2= Negative (3) IS,= IS (5) IS4b= rMzQu or Future Potential IS intersecting )1( ISr= (A) IS,*= IS shift of shift including shift IS due to shift ERr due to Aliyah due to Aliyah ERr Yp NX = (7)IS5b= Total IS shift including (6) and < 0 IS2IS3 correction (return to related I shock if IS ERr Import Surplus, in equilibrium Leftward at erosion and shift of related I shock if (6)158*= (9)"NX=Os88s = LM (2) and supplementary shocks to I Total IS shift incl. (4) and (8("NX=0B7= 4 shift of equilibrium > IS2IS3 induced return to at NX = 0B7) NX = 0a7 Yp import surplus in relation to Yp 19 .Y.^ Neither supplementary demand stimulus or restraint would be necessary If the positive falls short of the earlier negative shock to IS shocks, ISo moves to IS^a. In this event, this of brings ERy somewhat NX =0 toY to the left of ; Y . still but plus the correct rise (IS^ ) the ISLM intersection leaves In this case then, stimulus (monetary or fiscal) demand shock DD would be DD some supplementary domestic needed to and restore full equilibrium. If the positive shock to IS exceeds the earlier negative shocks )shifting IS 3 to ISga), the addition of the correct of IS to an intersection beyond Y_ (to IS5 ERr rise implies ). In this case then, restraint would be called for (to fully restore an demand some ISLM a shift domestic intersection onYp).24 Finally, imports we may note implies that the )not necesarily to Y ) that "NX = the more optimal case of "large" 0" line of Figure 4 would capital shift to the right without the need of a rise in ERr from its present )recessionary) position. This would not however, in this case, imply a rightward shift of IS; much but rather, would allow (and require, larger rise in domestic to reachY ) , a demand. 00 To simplify this analysis; we assume in Figure 4 that the LM line has been and remains stable (i.e. M policy is purely accommodative). Figure 3 also abstracts, as usual, from the rightward movement of all curves over time with potential growth (including the boost to the rate of potential growth (Y \ due to the Aliyah wave itself). This restraint includes by definition the increase in taxation which the government feels it must impose to finance at least part of its expected Absorption expenditure, as well as additional monetary or fiscal steps which might be taken as the recovery proceeds "to avoid excess demand." most Indeed, in this case, the required of) the work of both the "DD" and the Figure 4. DD ER shock to IS should do all (or shocks described in relation to 20 Figure 5: Projected Civil ®\+B with Present ERj.('89 '90) and Alternative Cyclical and AHyah Assumptions " (A) 0 Y = * 0 (B) Yp, ERr = 198990 Y = Ypj EHr = 8990 level in absence of Aliyah level: Including effects of Aliyah wave in effect Y gap (Bank of Israel memo. op. cit. "With Plan" without closing of the estimate). if (C)Y=Y .< |Y gap over each of Aliyan wave (appendix 1). )D) (see appendix I). wave Y = ■! Yp + )Coabmes &Y B first two gap over two years: then and C. ) years ; then =Y ; in absence of p = Yo; P' including effects of Aliyah wave. 21 Orders of Magnitude of the Cyclical and Aliyah Program Effects on the Figure provide us may 5 (before idea of the with some up) summing quantitative implications for external balance [i.e. civilian cyclical recovery It MX (MXg+S)] of and of the Aliyah program. suggests (in line A) that merely returning Y to the potential growth rate (Y_), without the effects of first closing the cyclical level gap, or of the new 198889 Aliyah wave, would have kept (say s 3.3* of GDP).27 Line followed by Y , MX C in the vicinity of its indicates that cyclical recovery without the new Aliyah related effects, (i.e. closing the gap created in 198889 over two years) would have raised GDP a levels in MX * 7* by about 5.5* of (to 8.1*). Line that, B suggests the effects of the without overcoming approximately suggests that Y_ (now MX would new Aliyah wave on the cyclical gap, the assumption growth goes increased by the Aliyah wave). forward at This projection rise from recent levels to temporary peaks of =12* of is based upon estimates in this paper (Appendix 1 below) of with cyclical recovery and upon model exercises in the Research Department (especially in a Bank memorandum, "Economic Policy in a Period of Aliyah," July 1990). These exercises assumed a total wave of 700,000 immigrants over four years and investment expenditure to achieve a )moderate) restoration of K/L ratios. They also assumed that increased capital imports will finance the bulk of the increased investment (so that, for example, "C" will not have to fall by more than a fraction of the rise in 1 Figure 5 the potential rise in MX and G). A statistical caution: The figures shown (in Figure 5) for MX +s )2.6* of GDP in 1989) are based upon balance of payments data. For reasons which are not entirely clear, different figures are provided for the same concept in the National Accounts (e.g. Chapter 1 of the Bank of Israel Report). 1989 MX registers as 5.0* of GDP in the latter data. For this purpose we use the "with plan" projection of the recent exercises a projection which implies a potential growth rate without Aliyah similar to that underlying the estimates in lines A and C (~ 5*), plus an average Aliyah effect of another 2%/year over the 19911995 period. model 22 GDP followed by a This would be (1992 1993). decline toward recent levels )5.^ in1995). 29 (in line When D) we years) recovery f/% over two peak levels of to 1718* of MX additional growth necessary for cyclical add the to the assumptions of line increase the B, we (followed by a decline to no less than GDP 119£ even by 1995). The )and we precise size of these potential rises in shall raise some doubts MX is of course debatable But that, in the best case, ourselves below). there would be a quite massive rise for both reasons cannot be doubted. Capital Import Versus Domestic Savings: discussion of Figure to the A) We have already that, if additional capital imports level which "offsets" (i.e. held merely were supplies the foreign currency for) the extra import component of the assumed Aliyah related program, appropriate ERr "target" at appropriate rise in ERr (in the seen Yp would then our have remained unchanged to reach that target from the eroded (and ERr the level of 198990). Capital M (as a substitute for domestic S) can only directly supply more net imports. If it is allowed therefore (or, more realistically, to finance a much larger part of the total I program (presumably optimal course, which would hold domestic r closer levels) , then this factor must push These encouraged) projections assume down at its earlier or world the equilibrium that the Aliyah a more wave ERy at Yp . essentially ends in 1994. on A general equilibrium diagram (see Appendix 5) makes this quite obvious. Capital import financing must "convert" the net additional resources needed for the I program into imports by 1"educing P,j,/PNT; thus inducing a shift of domestic output toward NT, and a rise in net imports equal to the additional capital transfer. 23 Unfortunately factors (e.g. we greater the higher L/K and optimal rise of capital imports). the "target" ERr at rise in ER rate. called for a , by the vs. DD the in uncertainty as to (e.g. whether the significant recovery alone, would now be decline of the equilibrium ER at points to an "agnostic" (or "wait and see") approach to the exchange return to Yp). It larger growth in domestic Y offset intensity of are therefore left the sake of cyclical Policy should still )i.e. We import over the next few years Y completely, or only partially, Yp). This the net effect of these counteracting cannot quantify and not merely the center upon the need for full initially would however now demand (with raised Y "I type" expenditure) would then seek this goal via a real monetary growth targeted toward of the Aliyah period). growth of the import surplus and of cyclical recovery The consistency of the capital imports (together with the rise of be monitored with a readiness to make ERj. adjustments if the evidence points fairly clearly in that direction. Model Projections, MacroEconomic Targets and Recommended Steps It appears possible that the projections described somewhat point to above the necessary I component of Aliyah related growth. make exaggerate The vital here, however, is simply that quantitative estimates of detailed elements should not distract policy from the central macroeconomic targets. Obviously, the above remarks are couched in terms of the present "adjustable peg" system: a floating ER would be a possible alternative (which ideally should adjust endogenous ly to the factors described; but which, of course, introduces its own uncertainties). It would also be possible, and even desirable, to estimate orders of magnitude of the net effect on equilibrium ER^. But because of the drastic size of the factors involved, these should only supplement, rather than preempt, the "wait and see" approach. 32 See for example the analysis of U.S. recovery from the Great Depression and wartime growth with little additional investment in L. Summers )1990). 24 Market forces , not central hence, the extent )and, planing will determine the size of the I wave 1 of the; "coiapositional" effect on MX) closure of the cyclical accompany the wave of Aliyah and the which will gap. At the same time, market forces will tend to equilibrate the rise in Ij and the shares of internal and external sources of finance (with the former rising, example, "countryrisk" raises the cost of foreign capital). Policy should concentrate on: <a) aiming domestic toward Y targets corresponding to Y demand and if necessary, EKy stimuli and, simultaneously toward an external balance consistent with "economic" capital imports; (b) creating a less restrictive environment for market adjustments within these This if for will allow greater flexibility to K/Y and macro targets. strengthen incentives for financing (especially via foreign direct investment) the large rise in I which undoubtedly will prove profitable. A the selfconfirming tendency of official "forecasts". The word about practice in Israel (not only here) has often been, in effect, to disguise national account targets as "forecasts", as if they were estimates of what virtually must occur without clearly distinguishing, or fully identifying, the policy and the exogenous factors While partly the which will in fact determine them. result of National Account conventions, this procedure tends " As a major example of the role of policy reform in expediting these endogenous adjustments; we should remove capital export restrictions, which have always tended to discourage direct investment and other forms of private capital import (partly included in the "transfers" items of B of P accounting). The remarks apply, for example, to "National Budgets" and to many internal papers as well. Only the fiscal policy variables gain some representation in the "forecasts" (as "real" components of the National Accounts) and even these only in "expost" values, rather than the "exante" values (i.e. change in full employment GT) which actually measure policy action. 25 shortcircuit proper debate to GDP growth). We over targets themselves (especially the rate of should try to resist the charm of this effect for officialdom; describe such estimates as conditional outcomes, given the policy settings, settings monetary, fiscal and exchange rate and include these policy in the published package. In this spirit of "Glasnost" we may again summarize the chief lines of policy .implied by the analysis of this paper; this time, taking into account the onset of the new wave of Aliyah from the Soviet Union. the recovery of internal and external )1) Our must urgent need is for equilibrium, together with rapid "absorption" of the entered an wave. The Aliyah wave economy still new Aliyah in the grip of recession induced in large part by complementary increase imports, the entry of in capital ER erosion. a Without a this massive labor increasing factor would probably only further raise the target )or FQ. level (i.e. the equilibrium encouraging) capital however, a massive would move ERj. atY ). Allowing (and probably optimal) inflow of the equilibrium ERr target in the opposite direction. This suggests a pragmatic policy of cyclical recovery led by domestic demand stimulus; with a "wait and see" approach to devaluation. )2) Policy. should concentrate upon needed for the finance recovery of of the Aliyah Y . the monetary and fiscal steps We should encourage external program aiming toward the optimal As noted, the structural changes in the economy involved are so exceptional that it seems doubtful that empirical estimates could restore the relative clarity of the "preAliyah" situation. 26 equalization of internal and external "r". Reforms (especially full convertibility) should be considered part of this toward process. )3) If we wish to do so, it is not precluded (although it is less urgent and adds complication) disinflation objective undermining GDP during this a fulfill period earlier our without again This could be done by the introduction of growth. a "second" temporary wagepriceER that such still to freeze. It goes without saying freeze (as in 1985) includes a temporary break in wage linkage.36 Some "Details" For on Real Devaluation, real devaluation to a )temporarily), along with, We and When Necessary^ effective, real be fall by the have achieved this adjustment. in general. P shock P index) (itself largely from W one could regard the predevaluation Wr as approximately level consistent with general (i.e. fall in the past, and can do so again, by an the weight of tradeables in the If must "external price shock" (EPS) of the agreed adhoc deletion of part of the onetime function of wages but more than, private real income Factor incomes in general must devaluation. If internal except for the income effect of ERr erosion, and a linkage at the external) equilibrium then the proper deletion (i.e. the EPS) would be determined by the weight of the import surplus. This would leave Wr or and other factor prices in the same relative position as before the See Appendix 4 on the inflationary potential of ER "upcreep" without explicit deletion of P effects from W linkage. 3' The following paragraphs expand upon the analysis in Ablin (1985). 27 the inertial devaluation. Since however, post EIL erosion of 1985 EIL prices); and world deletion of the entire was , W P centered in and Pnt (with V^ its must exceed Bj, restrained by general equilibrium level. While shock (given by the weight of tradeables in income) would be excessive (implying that would be reasonable to delete Monetary Policy: inflation which has underlain the erosion arose only from excessive EIL at least most of the W), it shock (say tf or tf).38 P growth should of course accommodate the expected M 0 P shock in the case of a devaluation as described above. If a second "freeze" were yf (e.g. undertaken (with or without a devaluation), greatly reduced. For (Ml M3n) should obviously be should be expected to grow more rapidly in this case.) cyclical recovery, Mr (M3r) must clearly )e.g., at an additional 3.5* per year for 2 be years). targeted in excess of Y This will in effect tend to accommodate , restrain or stimulate I, as needed. There is some uncertainty as Whatever the 4 Y_ to what must not be even in the short run. 5.5X of 1987 than the Z.5% of 19851988), forgotten that current during the. cyclical recovery. like may be assumed (we have seen earlier why the preAliyah rate was more likely to be in the vicinity of the it Y A few Y can and should be higher than Yp years of sustained growth at something levels should also begin to reverse the negative feedbacks which Yp worked to reduce Y in the past and to give Israel its long era of near This would, for example, imply an "immediate" W fall of about 5* (for and a one time AP ss 7X) . Some of my previous references to appropriate deletion of devaluation induced P shocks gave inadequate weight to the probable upward distortion of Wn/P^. (A more detailed clarification of the issues involved is desirable, but must be reserved for other occassions.) a AEI^=15* M policy more generally. Even when ERn was held fixed cycles" allowed) capital mobility was far from precluding counter cyclical M policy (Tal and Elkayam, 1989). Until our (still distant) merging into a larger state, national countercyclical policy, although requiring changing modalities, will remain an important challenge. A )and "EIL word about 28 stagnation. can, however, leave We this pleasant prospect to the test of the future. Afterward: Our discussion should not close without noting a degree of recent convergence of actual policy (especially during 1990) with the recommendations given above. stabilizing ERj. From merely halting the long erosion trend (following a partial correction at the shifted toward a gradual "upcreep" of the start rise a 4 Bank and and of 1989), policy rise ERr. This achieved a cumulative of about S.5% over the 1988 level as of JuneAugust1990. 41 published by the "PreAliyah" then The program the Treasury in September proposed to add to this percentage point cut in Employer's National Insurance taxation. For trade, such a step approaches a similar rise in theERj, . Operating in the opposite direction (by perhaps the equivalent of a one percent cut in ERj. ) the Treasury reduced the "export insurance" premium for export earnings. These steps together ERj. would imply a moderate levels of 198889 as we rise from the "recession" enter the era of the Aliyah inspired surge in investment and other domestic demand. In contrast to past tendencies, should be willing to raise i^f the ER_ further, rather than choke off demand growth, rise of the import surplus with cyclical recovery clearly reasonable limits for capital we exceeds any import. But, as noted, whether this will occur is quite uncertain. " Such feedbacks are recognized in the literature on "hysteresis" )Summers, 1990). See also partial measurements for Israel in the. 1970s (Ablin, 1979). . : * A serious drawback in this tactic has been that it has ignored explicit deletion of "P shock" effects from W linkage. Experience suggests that we still need such explicit deletion, especially when we move (as we should) out of the position of cyclical recession. (See Appendix 4.) kZ As of this writing however, this step has not been implemented. ■ 29 By visible. late M3r 1990 a further convergence, this time in monetary growth became its flat trend broke out of during 1988 and 1989 and headed towards a rise of 5. 56. 096 during 1990. This change apparently represented shift toward accommodation of Y , but should clearly be carried to a somewhat higher rate to support the closure of the Purs\1ing GDP gap as well. policy of "orthodox" disinflation against our post a residual inflation, 1987) until mid1990. effect waited for an unexpected accident the great Aliyah episode should do this now be 1985 failed to conduct a countercyclical policy from the we start of the current recession (in late U.S.S.R. to a work for us (that is, to force us to We have, in wave from do it). the This put definitively behind us. The problem of our remaining relative inflation can be handled, either now or later, without returning to this excessively costly treatment. This is reminiscent of the failure of the U.S. government to achieve true recovery from the Great Depression, until forced to do so by the need for rearmament in 19<+0^l. The difference however in macroeconomic knowledge and experience is obvious. 30 Appendix X GDP, 1 National Budget Forecast and Actual 19861989 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 National Budget Forecast 0 0.5 1987 1986 1988 above diagram demonstrates The 1989 that as late as January 1988, year into the growth recession), there was no recession in 1988. The 1990 official expectation of (i.e. j a growth recession appears in the forecasts only in 1989; \\ years after its actual onset. in this error lies in the forecast of export growth The major element )g+s). This is clarified in the following numbers: Implied ifYandM = (ER . = Mg+S2( imports) 3.9 2.9 Ag+s Forecast | Impliedif actual levels) Y = 5.4 2.9 GDP Difference in as *GDP 1.9* NX(xM) are based on the conservative assumption that the short 1.0, and that there is no SR elasticity of X with For computations reflecting such cyclical nonprice These estimates run Y elasticity ofM respect to Y. 2.6 +s = elasticities; see below. Excluding direct defense imports. !i.2%1 31 The calculations above decline of at NX at least22. by Y the recession (i.e. via a rise in actualized that in show this rise in the erosion of ERr generated a 5* of GDP. Thus, avoidance or without correction of the DD) deficit NX 1988 the at Y This . situation EB reversal of would have was not altered fundamentally during 1989. A ERy set of rough estimates which take account of the elasticity effects of (current and previous yea::), and of the greater than unity changes elasticity of Imports with respect to it deviates when Y from Y ST (i.e. the cyclical non price effect) gives something like the picture presented in table 1 If (1) below :J Y in stable at the (slightly roughly unchanged from the same would fall by say, additional rise in (7*) MX may EB^ rise improved) 1989 its low 7*, and Y Y J and ERr average rate, then billion at 88p). If, with ERj. erosion trend were allowed, average (*A of NIS could rise by over 2.0* of sufficient to close the A GDP, (if ERj. Y gap created were GDP. in MX ER" (3) With an 1988 and held stable) and by 1989 8X, if latter figures far above) its 19871988 level. preliminary check, as well as economic logic, suggests that, if they include the similar far below (i.e. should remain MX erosion were allowed to continue. Note that either of these imply 'NX' is held level MX by over 5X (assume * 5% 1989 of the resumption Y, to moves up 1990 vital ERr effect, other estimates would provide a qualitatively picture. These are broadly based on elasticities suggested by the literature on 1979; Lavi and Beenstock, 1990), with some "assumed" corrections for changes in Y growth rate trends. (See table 1, note 2 below.) this subject (e.g. Ablin, 32 Table 1: Conditional Estimates; 19871990 )All figures in 1988 prices Billion NIS) (1) (2a) (2b) 1987 1988 Actual 1988 (88p) If 1 Y=5^x (3) (4a) (4b) (4c) (4d) 1989 Forecast 1990 1990 1990 Y=12^2 1990 ER=0 ER7£ ER 30.0 M h 24.6 (7.8) 24.2 With actual 31 r5 31.9 )4.5) (5.9) 27.2 26.0 26.5 (3.0) (2.0) 5.9 8.1 9.8 24.6 25.8 5.9 7.6 4.4 2.9 1.5 0.5 ERr (of (6.6) (3.3) 1987 and 1988), (5.8) (0.9) .3 0.1 (0.2) plus continued Y 34.6 (15.0) 1.6 3.7 (2.3) (5.6) at SS in growth 1988. These columns compute the effect of the closing of the Y gap as if it occurred in one year (1990). This is only for computational simplicity. The factors taken into account in this exercise(ER Y and Y gap) would yield a similar AMX for a slower cyclical recovery. The implicit ?licit equations are: are:MM. = 5,0 + 1.5(Y5.0) 0.2ER". , , O^ERp.j X +g = 5.0 0.4(Y5.0) 9 + 0.7ERT CSERj,.! Excluding direct defense imports (i.e. civil imports g+s, as shown in the National Accounts). Appendix 2: Wr and the Aliyah Wave It is not difficult to gain )assumed to a total 700,000 in the significant absolute fall in While this determinants would be (K, some Bank Wr the obvious to idea of whether the wave of Aliyah of Israel July exercises) would require maintain full employment equilibrium. result of a K jump in L , total factor productivity) constant; there fair chance that the cyclical recovery effect rise of Y=12^2 (0.2) (2.4) (0.7) =0 30.1 (1.9) &MX CSS GDP) I.e. 32.2 (0.0) 5.4 MX J 30.0 Y=5* ER=7 on "TFP" and with all other appears to be a a (accelerated) over the time period of the wave, will avoid this.additional strain. 35.1 (16.4) 25.2 5.5 (8.1) 33 perform a We exercise here assuming a "neutral" rise in simple compare the outcome with that implied (for Wr) by the Bank L . and of Israel July projections. Suppose the additional entry to the labor force occurs in four years )19911994). at an annual to ~ 5tf total average of 4* of the Labor Force (raising aLS per year) and that this labor requires a one year lag to be absorbed into employment. We . AL &K A obtain the following: 19911995 ( 5%/yr) 19911995 ( 3%/yr) = = IFfect 22.7* 15.9* Total Factor Productivity (TFP) (2. 5%/yr) = 13.0* Multiplicative Total = 37.1* Implied rise in Y/L (average labor productivity) It will the reader that be evident to = 137/123 We L and K TFP. The latter in fact rose utilization five years simple exercise with July projections, we find, shown elasticity of in both K and Y (2) in in 1990 by about 3*. is also higher, the implied result despite differences later are consistent in broad outcome Specifically they imply a rise in Y 1 a simple given a upswing and the rise in human capital.) Comparing this Israel assumptions about the rise by 2.8*/year in 198687 and probable rise over the )The +11* corresponding to their shares in factor income). used very conservative have = applied CobbDouglas production function approach (implying a marginal with respect to Y 13.0* have here (1) we on (x.67) = 15.2£ (x.33) 5.2* and even of the Bank of in detail, slightly more (Business Sector) of about 50* q that the favorable. (to 1995), realistic case of a rise in L possessing more human capital, will only ten! tend to raise average productivity and equilibirum Wr, relative to a neutral The more rise. 34 based upon somewhat larger percentage rises in rise in This yields a Y/L of about 21*, and, rise (in these projections, a fall in implicit rise in The Wr L (27*), K (30*) and TFP (£183). after absorbing an assumed "ERr" /exports) of 7*, this leaves an W /L of about 13*. important result is that, although the faster rise of rise in average labor productivity which might otherwise take place, would remain to allow both a negative adjustment of that proves necessary (as net rise in Wr we this is uncertain), plus have seen, enough with a rise in W the slows L EIL. , if moderate a over the period as a whole. should note however a few qualifications: (1) There is the possibility We of a moderate "squeeze" during the first half of the five year period, due to the earlier bunching of the rise in L, in However, the surge L and inevitable lags in that of K. implies an end, and at least partial reversal, of a large previous slump in capital utilization (due to the 19881989 recession). This provides a sharp stimulus "absorption" of both additional elasticity of L than the LR during this period. to TFP K and L might imply a a lower would not above even in the offset the probable surge in recovery level of realistic elasticity L Y may LR. by the Fortunately, SR above not be CobbDouglas and TFP, (even during this period). (3) source of concern, if significantly lower elasticity implied (CobbDouglas) approach; or the relevant production function imply (2) Lags in the may this difference less so, with a true Finally, and probably our most the total number of immigrants rises greatly the figures assumed above, there is greater chance of encountering Note that statistical L" elasticities in general (e.g. Beenstock, 1990) suggest figures lower than the implicit CobbDouglas elasticity of 3 (But figures in the vicinity of 1, which tend to occur in these studies, necessarily reflect short run frictions, since they would imply a marginal product of labor of zero). =5 35 external capital import "constraints." This K/L and provide a separate burden to PDY, would both delay the recovery of insofar as it necessitates more financing by taxation. These qualifications notwithstanding, the exercises shown here should help to guard against a widespread but unsoundly based pessimism. Appendix The monetary growth represented * by Mlr 3 Data Underlying Figure rates for the recessions of 2 195253 during the year (DecemberDecember). 1 E.g. during the year (1966) following the prerecession the Mr GDP then known). The next Mr (e.g. 1967) shows the For 198890 however, M3r ER "1966" shows level (the last M policy during GDP. is shown, to avoid DecemberDecember changes due to on a YearYear average basis significantly distorting fluctuations in the GDP reaction in the year following publication of the first recession year the and 196667 are speculative cycles in this period. (The DecemberDecember figures essentially the same show story especially if smoothed.) A "wide" monetary aggregate such as M3 is not readily available (and of less significance in comparison to Ml) for the earlier recessions. 36 Monetary Responsein Thre e Recessions (Yr GDPr) = Mir M1r 1952 First year of recession M3_ 1966 1988 24.0 1.5 3.0 2.0 2.1 3.0 12. V Second year of recession 1953 1967 1989 5.3 3.8 0.7 26.1 1.3 2.0 2TT01 Third year of recession 1954 1968 1990 or recovery 16.3 a DecemberDecember b As .U7 (not smoothed) = 11.5 12.1 (5.2), 1988 3.4 (1st h) (4.9). 1989 Klinov and Halevi, (Y. Weiss), 1968; Figures adjusted for suppressed Appendix 4: ERrUpcreep , NonDeletion and We have noted, in the proposed employer national insurance taxation Of ERy. somewhat "upcreep") inflation , more not implemented) than relative escalation by the reduction of VAT contains no inflationary potential, Israeli while directly raising these, with revenue offsets through higher although subject to certain other qualifications . by Inflation Risk final section of the text, several recent actual or steps relevant to the defacto )proposed, but still !ז. ERj. , WPI The policy of raising EJ^ (i.e. ERy inflation however, has run an unnecessary risk of neglecting the step of explicit deletion of P To obtain the implicit rise *n Pj/^NT with this measure requires negative flexibility of PNT (whereas an equal rise in ERlf directly raises PT ). This measure also differs from a rise in ER in providing no direct stimulus to capital imports (i.e. via a rise in the real NIS value and hence the purchasing power of foreign, capital over domestic assets). 37 .shocks from W linkage ' Summary "Revealed" Actual Real Exchange Rate Policy * Change ERj^ )WPI average 1985 1986 average 1987 1988 1988 average IV. average 1989 average 1990 1st five months 1990 JuneAugust "if ' index) from 1985 108.8 100.9 97.2 85.3 87.7 89.4 6.6 10.0 21.0 18.8 17.2 92.9 14.0 90.316. A Inflation (n) Escalation Potential8 )1) "Extra" Eofn (i.e.E*Rn rel. WPI) )1988 to JuneAugust 1990) )2) "One Time" AP shock~ )3) Net AER (before "Echo") (4) External Price Shock (EPS) relevant to ( o/o ) ~ 8.5 2.8b 5.5 * 1.9 W )assume 2/3rds of (2)) )5) An/ Period (Period=half year) "Period" = 1.0 half x EPS "lag" 0.67 half )6) *An at annual ratea 2.8 5.7 Footnotes to above calculations: a For formula used in this estimation, see Ablin, The accumulated P shock of this gradual "extra" )1)) is here assumed to be one third. From the 1985. devaluation (shown in data, this appears to have been closer to the actual event in this period than the earlier normal relation of about one half (related to weight of tradables). This appears to reflect the repressive effect of recession and rising U. 38 Thus, the accumulated upcreep of deletion from W ERj. linkage created a potential earlier portion of this (up to early to August 1990) without (1988 n escalation of about 1990) may have been 5.73£. EPS The partly (or largely) suppressed by the pressure of recession but most of the P shock is concentrated in to offset the quarters of arid 1990, and the decline in the effect although still n which became WPI 1990 (from about 1617* Appendix 5: The LS not clear, threatens apparent in the first three to about 12£). Surge and Potential T and NT1 A B / Diagrams A and B clarify several possible impacts of the Aliyah related surge J in I3 per se (i.e. See Dornbusch (1974). Ablin (1989). upon ERj. equilibri unr excluding the effects of 39 capital import.* illustrate They to determine effective combine Diagram A )with physical policies determining both how GDP and ERr DD demand (Yd). pictures the (unrealistic) simple case in which the rise of lagging behind) raises the potential output of K L "T" and "NT" proportionately. But it gains in relevance because it also reflects the situation in which, despite the lag of physical "human KV in the new particular case in homogenous , L/K which rise, favors T. It L , K, interpreted as showing the may be this effect just offsets the normal effebt which favors service component). Since at the (largely NT pictures the favor output of PPCg. NT, more normal case expanding the production In this case, equilibrium requires inEPj. ) and , negative inflexibility in further ER^ a movement *n PT^PNT = ERr) AL . in which the 1? possibility curve fall in to PNT surge tends to from ,relative to PPC^ Pm to (a rise pointAto B (the tangency of PPC2 creates several possibilities for trouble if there is full equilibrium shifts with P0 line 22). This the latter 's higher due to this position simply requires a proportionate rise in B of a equilibrium (B), no change in the slope new of the P0 (priceoutlay) line is needed (ie. Diagram the larger endowment of PNT and from unwillingness to raise P^ by means of adjustment: )1) Suppose the expansion of aggregate domestic demand (i.e. PriceOutlay line) is held to equality with that of tangency with PPC, ). In the extreme case flexibility) this shifts Not all effects " compos it ional " us to PO 33; (i.e. no tangent to Y_ (i.e. to negative PPC2 the at P^m C. C discussed in this paper are illustrated (e.g. the effect on import demand which would here imply a change in the shape of the community indifference currves). The effect of a large increase in capital imports is considered below (Diagram C). temporary ; 40 is only the position of "preferred" output; however of equilibrium in demand is then at of output, initially importsof )2) gap); it (i.e. E a result is a constraint recession gap), new and net T = DE. get output up to the To Y to The D. the position new PPC curve (and avoid a raise domestic would be necessary to new or enlarged demand to PO 44 1 )i.e. by more than the rise in at which level of for T (at goods (on C PPC 2) . The F) would then have still greater to be satisfied a still larger rise in imports (to FC). by The )with preferred output is at demand to the "highhalf equilibrium" Y ) appropriate policy in this case would be to ease the shift to its full equilibrium tangency at T B) by a rise in EIL PO (and hence in 22 PT ) c ,r1 'c ייי . r T, w V ; 1 i Nc ER_ N, PPC NT This refers of course to a rise effectively translated into a rise in of appropriate deletion of P shock effects from W linkage. by means 41 along with the YL The an accommodative rise in K and hence in DD to the C~ rise in as in (1) above). Effect of Large CapitalImport Diagram : potential large capital import, attracted consequent increase (in the absence introduces the effect of the C the rise by of and the L/K of rising capital imports) in both the marginal productivity of physical capital and the domestic real interest rate. qualitative effect is straightforward: The which would otherwise spent directly on T. But to simply original equilibrium point P fall. curve.) equilibrium new M P2 same level of NT AB of through much T relative price and T to the TNT can only be combination at the consistent with equilibrium B would not be tangent to an in demand, its (PT/PN^ in production, =ERj. ) we (A P relative price must which would yield require a price line tangent to an indifference curve; whose parallel price line, excluding the capital P2 this in both demand including the Capital at the PqPq To add find the To add This, by nature, = AB. (A); would not be line wit the slope of indifference ER prevail. (rise in) capital import Suppose a lowering of the equilibrium a M, is tangent to the production possibility curve (for which production and consumption must be equal). represents this line. With this relative This result was P (ERr), some domestic production first clarified in the debate shifts to over the NT (thus classical and has become well known in post war literature in connection with such phenomena as the "Dutch disease," the OPEC revenue boom and even the earlier (19501960) phase of Israeli development. "transfer" problem Note that ^^2 is slightly steeper (i.e. has a higher Pf/P^T ratio), "B" (but would leave than a line (PjPjy which would equilibriate demand at desired production of NT in excess of demand). 42 allowing the capital consume at There D; M importing to indirectly "buy" CD is, of course, Diagram, G would here) As NT). We produce at. of T (= no apriori; assurance that the capital G and AB). fully offset the opposite effect of Diagram plus the needed rise in ERr from diagrams.) to some B; we effect of or the latter, its recession equilibrium (not noted in the text, this poses problems (which M shown in do the not tackle for econometric research, but, from a practical standpoint, strong arguments for a flexible approach to the real exchange rate. 43 References Ablin , (1979) ,. R. "Israel's ForeignTrade Demand and Economic Reviewi No. 4546, February. Price," Bank of Israel )1980), "A Lost Decade of Israeli Growth? Economic Policy Since 1973," Bankof Israe l Economic Review, pp. 4849. (1985), "Inflation as the Equlibrator of W in the Israeli Economy," Discussion Paper, Bank of Israel (also, Bank or Israel Review, No. 63, 1988). 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Melnick, 88.06 Policy Durimg Disinflation: Israeli Stabilization Program of 1985 Z. Sussman, Wage The M. השפעת שינויים במבנה הותק, קלינוב. ר, אמיר.ש . גישת הקבועים והזמניים:19721983 ,השכר BenGad The M. The Demand for Liquid Assets in Israel, 1970 1985 M. Beenstock, Mishel Kahanaman The Trade Balance Ratio and the Real Exchange Rate in Israel 1955 1986 A. Offenbacher, M. Beenstock, ShortRun Monetary Control in Israel A Cycle Democratic Model of the 11RentSought" Benefit 88.09 88.10 88.11 88.12 47 1989 הריבית הריאלית והנומינלית על החוב הפנימי ,פיטרמן ,ס ,אורבך .צ 89.01 .והחצוני M. Beenstock, The Factorial Distribution of Income in the 89.02 Union Bargaining Model R. Ablin, Erosion of the Real Exchange Rate; Demand and Growth A. Bregman, M. A 89.03 Diagrammatic Clarification Fuss, and Israeli 89.04 סקר החברות, פישר. י, גבע.7 89.05 Haim Regev HighTech Firms in Industry. ,בנק ישראל בחינה מחודשת R. 1983 של Melnick, Forecasting Short Run An Evaluation ,המשק Inflation in Israel 19831987 נטל הריבית על האשראי הבנקאי לזמן קצר בענפי, בןרוה.י 89.06 89.07 .1988 עד ,קטור העסקי0ה A. Bregman, משק של בענפי על ההשקעה השפעת שערי הריבית, לביא.י .1987 1962 במשק הישראלי 89.08 . הרפורמה בשוק ההון יעדים ותוצאות ראשונות, בןבסט.א 89.09 Technological Progress, Structural Change, and Productivity in Industry: The Case of Israel. 89.10 . מדדים למחירי מוצרים סחירים ובלתי סחירים, בןבסת.ע Leora (Rubin) Meridor and Shula Pessach, The Balanceof Payments Offset to Monetary Policy: An Examination of The Israeli Case. 89.11 89.12 4S 1990 Leora (Rubin) Meridor, from Stabilization to Sustainable Michael Bruno £ The Costly Transition Growth: Israel's 90.01 Case. Monetary Aggregates and the Balance of Payments: Israel, 19701988 David Elkayam and Yitzhak Tal, 90.02 Richard Ablin High Interest Rates, Spreads and Margins in Israel 90.03 An Analytical Review Shula Pessach and Assaf Razin, Targeting the Exchange Rate: An 90.04 Empirical Investigation Avi BenBassat and Daniel Gottlieb Optimal International Reserves 90.05 and Sovereign Risk Avraham BenBassant and Daniel Gottlieb A Note on the Effect of 90.06 Opportunity Cost on International Reserve Holdings ההתפתחות הכלכלית, "קשרי גומלין בין התפתחות הרכב הגילים,מלכה ברון "ושיעורי הנישואין והילודה בשני העשורים האחרונים עם במודל מסורתי ובמודל, "השפעת הריבית על הצריכה הפרטית,יעקב לביא "19881962 ,צפיות רציונאליות; מימצאים אמפיריים "הגורמים המשפיעים על משך האבטלה של פרטים הזכאים לדמי ,סיגל ריבון "אבטלה 90.07 90.08 90.09 49 1991 Rafi Melnick and Yehudit Golan Measurement of Business Fluctuations in Israel. כוחות שוק:שכר בישראל עליות של "דינאמיקה, inoir .y , vototim. "והשוואות בינענפיות 91.01 > Meir Sokoler Seigniorage and Real Rates of Return in a Banking 91.0;! 91.03 Economy Edward K. Offenbacher Tax Smoothing and Tests of Ricardian 91.04 Equivalence: Israel 19611988 בריה"מ עולי "קליטה בתעסוקה, )קלינר( קסיר. נ, פלוג. ק, עופר.ג ." והחלפת משלחי יד. היבטים של שמירר: והלאה1990 בשנת של "פערים ביו בכירים וזוטרימ ומשברים במערכת, זכאי.ד ."1990 עד1974 שכר הרופאים בשנים , זוטמן.צ :ציבורית 91.05 91.06 Michael Beenstock, Yaakov Lavi and Sigal Ribon The Supply and Demand for Exports in Israel. 91.07 Richard Ablin The Current Recession and Steps Required for 91.08 Sustained Recovery and Growth.