On the fit of a neoclassical monetary model in high inflation: Israel 1972-1990

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.