Foreign trade shocks and the dynamics of high inflation: Israel, 1978-1985

The purpose of this paper is to provide empirical answers to questions related to the propagation of shocks in a high-inflation economy. Do one-time shocks give rise to long-term persistence of inflation? Do foreign trade shocks trigger a process that, through indexation and monetary accomodation, results in long-term changes in inflation? Within the context of a specific hypothesis, influential both in policy discussions and in economic analyses, the paper addresses these issues using Israeli data and vector-autoregression techniques. The evidence does not support the hypothesis from the 'inertia approach' that one-time nominal shocks have a persistent effect on the inflation rate, or the hypothesis that long-term changes in inflation are triggered by autonomous fluctuations in the trade deficit.