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Monetary Correction and Indexation: the Brazilian and Israel Experience

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Monetary Correction and Indexation: the Brazilian and Israel Experience This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Explorations in Economic Research, Volume 4, number 1 (Indexation, The Brazilian Experience Volume Author/Editor: M. Ishaq Nadiri and Affonso C. Pastore, editors Volume Publisher: NBER Volume URL: http://www.nber.org/books/conf77-1 Publication Date: 1977 Chapter Title: Monetary Correction and Indexation: The Brazilian and Israel Experience Chapter Author: Ephraim Kleiman Chapter URL: http://www.nber.org/chapters/c9237 Chapter pages in book: (p. 141 - 176) I 140 Roberto B M Baer, Werner arid Beckerman, Paul. "Inflation without Distortiijnco An Fva(uatio5 Brazil's Indexing System.World Development 2 (Oc(ober.Decemher us 1974; 354' Carva(ho, Livio R. A/. Pnncipios e Appleaç,)o cia l'ii/iti(,i Saiarjal Pn5I 964 Dis( Paper No. 9, Universidade de Brasilia, Departamento rio tcon1 0550, l<73 Costa, Ramonaval A Size Distnhut,on ci Brazil in/ i)7: A ( ruc5_Si'it, Anaivs15 income Distribution by Occupations. Ph.D. Dissertation, Vanderbilt Unversity, 1975 DIEESE (Departamento Intersindical de EstatIstica e Estudos Sócio /\fl05 do P011/IC a Salarial. Estudos EconOmicos No. 3, Sao PauloEconomic05; Oez 1975 Doeringer, P. 8. and Piore, M. J. Internal Labor Markets and Manpower Lexington: D. C. Heath and Company, 1971. 'naf1,5 Fishlow, Albert. "Brazilian Size Distribution of Income," Amer,san f(OflUnj( Review (May 1972): 391-402. 62 . "Indexing BrazilianStyle:Inflation without Tears?" Brookings Papers on Economic Activity No. 1, I 974, 261 -280. Hoffman, Rodolfo and Duane, joo Carlos. "A Distribujco de Renda no Brasil "Rev5 de Administraçao de Empresas 12 (June 1972): 46-66. t.angoni, Carlos C. Distribuiçäo da Renda e Desenvolvi,nento EconOmjco d Bras;) de Janeiro: Editora Expressao e CuRura, 1973. Rio Macedo, Roberto B. M. Models of he Densanci Soc Labor and the Problemo Absorption in the Brazilian Manutacturing Sector. Ph.D. Labor Dissertation Harvard sity,1974. Unjvr. .. "Atgumas Dificutdades na lnterpretaco dos Dados do Salárjoe Sa(ánjo Mf'o da IndOstnia." Plane jarnenro e Conjuntura 79(August 1974)' 63-67. Rezende da Sitva, Fernando A. Avaliacâo do SetorPublic0 na Econornja Brasik'ira de Janeiro: I.P.E.A.-I.N.P.E.5,, 1972. Ri Supiicy, Eduardo M. "Alguns Aspectos da PoliticaSalarial." Revista de de Enupresas 14 (September 1974): 32-45. Administraçao lb. Tolipan, Ricardo and Tinelli, Arthur Carlos,eds. A Controvercja Sobre Dustribwçao d Renda e Desenvolv,mentoRio de Janeiro: Zahar, 1975. von Doellinger, Carlos and Cavalcantu, LeonardoC. E'npresas Muirinacjonajs tria Brasj/eua na indüs- Rio de Janeiro: I.P.E.A._l.N,P.E,S,,1975 Wells, John. "Distribution of Earnings, Growth, and Structure of Demandin Brazil During the Sixties." WorldDevelopment 2 (January 1974)' 9-24. [PHRAIM KLEIMAN The Hebrew University and the Falk Institute MonetaryCorrection and Indexation: The Brazilianand Israeli Experience 0 0 0 Ill INTRODUCTION devel- The growing interest which indexationproposals have attracted in whether e oped economies in recent years hasinevitably raised the question jndexation has been a success in the countrieswhere it was adopted in the 5- repeated elsewhere. This past and whether the latter'sexperience could be the three countries paper compares the operationof indexation in two of Brazil arid lsrael.i Without pre- where it has been extensively practiced: above, I suming that such a comparison can answerthe questions raised and differences in theexperi- hope that, by pointing out the similarities insight into the rele- ences of these two countriesit may provide some vance of indexation to solvingproblems faced by others. tend to regard it as a panaceafor The advocates of indexation sometimes it for not beingthat. all inflationary ills, while its critics tend to deprecate therefore, To keep the limits of the present discussionclear, let me start, indexatiOn and whatthe with an attempt to define what is meant here by monetary ends areitis supposed to serve.Basically, indexationOr ad just- correction, as it is sometimes calledis aprocedure of automatic the social and ments of nominal values, used as a deviceto minimize 1PF.NBER Seminar on indexatiofl,São Paulo, This is an expanded verSion of a paper read at the NOTE: draft I owe a debt ofgratitude to lose professor Februan' 26-28 1975 for their most helpful comments on an earlierBeckerman, and DonPatirk Robrto Novacs de Airne idaEctmai Bacha, Werner Baer. Paul and patiently answeredmy Novaes de Alnida alyew kindly supplied mewith essential Brazilian data m3ny queries. 141 V 142 EphrainiKleinian economic costs 01 ifltlatIOil. Consider tirsi the case where inilation devel. opc tinexpectedlv. after a period of price ctahi IitySince it was not taken into accou nt in the formulation of cx isti rig noni i na I contractstheir real outcomes will ex post differ from those envisaged by the cx ante on the basis of which they were signed; and the divergence bete0premises two sets of outcomes w;l be greater the longer the period of the the and the smaller the possibility of reopening it during its COntract Originallyagreed. upon lifetime.Itis these conditions which give rise tothe conclusion thatinflationresults in the redistribution of common income from creditors to debtors and, to a lesser extent (for wage contracts arcgenerai, of shorter duration), from labor income to profits. Unless inflation induced expressly for this purpose, the resultant redistribution was is one ofits major social costs.It will also result in a waste ofresources Caused attempts to force the revision of contracts through suchacts as strikes Furthermore, some resource misallocation may alsooccur, since the real price actually paid for goods and services supplied under existing Contracts is artificially lowered below their future replacementcost. Suppose now that inflation persists. The values at whichnew Contracts are now signed may be expected to take into account future declines in the purchasing power of money. And it is sometimes arguedthat if they do this correctlyi.e., if the expected rate of inflation incorporated intopresent contracts is the one that will, in fact, materialize__continued inflation will result in no further distributive or allocative costs beyond those incurredn the initial stages and, from the point of view of the individual, theinflation tax on the cash balances he voluntarily choosesto hold (which may turn out to be less distortive thanany other alternative tax considered). How. ever, this argument abstracts from both marketimperfections and the uncertainty factor inherent in inflationarysituations. Economic agents should be regarded as faced not by a point expectation of inflation,but rather by a spectrum of inflationaryvalues, with different probabilities attached to them. If,as we may assume, they are risk-averters, lenders will then demand a nominal interest rate which incorporatesnot only an element of compensation for the expected (mean) decreasein the value of money but also a premium tocompensate them for the extra risk element involved; and, for a similar reason, the nominalrate offered by borrowers, while augmented by the expected rate of inflation, will alsoincorporate a negative, clisagio elenient, reflecting their aversion froni thissame risk. The effect of uncertainty on the ex-ante real interest rate dependson the relative a strength of risk-aversion in the twogroups; but whatever its direction, it U will result in a decrease in the total volurniecleared in the marketi.e. ii n the total volume of saving and investment.1As uncertainty increases with the length of the time horizon, this lastresult will be accompanied bya (r change in the time structure of credittransactions, away from long-term tic 01 143 Correction aridIndexation st netary With the collapse ofthe capital market, the silvings rio longer contrai_ts. channelled into it arediverted, partly to current consumption, and partly to particularto stockpiling and the l)lirChaSC of direct realinvestnlent-111 and durable consumergoods. Thus, evenvhc'n prices and real estate expectations (but With uncer- e interest rates canadjust in full to inflationary resource misallocationis unavoidable. And it, cx post, the tainty present) from those expected, a redistribution of rates of inflationturn out to differ n be added to it. income will market institutions In the absenceof institutional and legal restrictions, ly expected to adjust to this situation,albeit often with a costly time may be S he recoritractirig, allowing the lag. One suchform of adjustment may its of existing contracts and obligations.However, such frequent renegotiation problem is therefore one of adjustments are farfrom being costless. The -S. cheapest to operate, both choosing that adjustmentsystem which will be al it will be unable in terms of the amountof misallocation and redistribution ts of operation. Indexation can be to prevent andin terms of the actual costs by viewed as a device simulatingthe market adjustments made necessary cts developments in the inflation, but at a lower cost.To illustrate, consider he brought about in full labor market in ademand-pull inflation, such as is is of pure employment by governmentdeficit financing. Under conditions nt the value of marginal competition, as output pricesrise, and with them also II workers from their product of labor, individualfirms will try to attract in will finally he competitors by offers of highernominal wages. Equilibrium 011 before, but not before some re-establishedat the same real wage as rn Alternatively, with a reshuffling of labor among enterpriseshas taken place. ) W- will result in highly unionized labor market, theinitial fall in real wages the of existing wage demands for nominal wage risesbefore the expiration nts lost, either in the contracts. In both cases, someworking time will he but through industrial process of workers' transitionfrom one firm to another or ties change that disputes. Assuming the change in the pricelevel to be the only viii through wage has taken place, the same adjustmentcould be attained an raised proportionatelY contracts stipulating that thenominal wage will be e of man-days would whenever the price level rises.
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