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country's balance of payments (its total international transactions for a period of time), which
cannot all be successfully managed all the time by policymakers. A black market exchange rate,
based on what ordinary people and businesses think the currency is really worth, inevitably
develops alongside the offi cial exchange rate. For a small country like Israel that is heavily reli-
ant on foreign trade, the exchange rate and the policies adopted to manage it play a major role
in the economy.
Although Israel periodically devalued the lira in the 1950s and 1960s, the exchange rate
remained relatively stable until infl ation began to gather steam and the country's balance of
payments deteriorated after the Yom Kippur War. In response, the government adopted a
crawling peg in 1975 under which the lira depreciated in value at a steady, predictable rate of
about 2 percent a month. When the Likud Party took power in 1977, one of the few concrete
steps it took to liberalize the economy was ending most currency controls and allowing the
lira exchange rate to be set by the market (to fl oat). But without other measures to correct the
economy's serious imbalances, the policy was a failure.
During 1983 and 1984, Israel resumed fi xing its currency (by now called the shekel) and
reimposed exchange controls. However, neither the lira nor the shekel exchange rates were
stable during the years that the exchange rate was fi xed. The government frequently stepped in
to readjust its value lower, sometimes by as much as 20 percent at a time; but it was the govern-
ment that set the rate, not the markets.
The modern era for currency began, like much else in Israel's economy, with the 1985 Eco-
nomic Stabilization Plan and the end of hyperinfl ation. Together they created a foundation
for a more stable shekel and enabled the government to embark on a slow evolution toward
a free-fl oating currency — this time with all the elements in place to make it work. In 1989,
the fi xed rate was made more fl exible and responsive to the market, allowed to trade up to 3
percent above or below a midpoint set by the government. Over time, this band was widened
to such an extent that, for all intents and purposes, the shekel was free fl oating. The Bank of
Israel, which was responsible for the exchange rate, would intervene only if it reached either
end of the band.
As the band grew wider, Israel acted to remove controls over buying and selling foreign cur-
rency. In 1989, for instance, it began to lift restrictions on capital infl ows, enabling Israelis to
borrow abroad; and in 2004, it abolished taxes on investments. By 1997, the Bank of Israel no
longer needed to intervene in the foreign currency market to ensure the shekel exchange rate.
Finally, in June 2005, the band was eliminated, and the shekel exchange rate offi cially became
completely free fl oating.
Thanks to the performance of the economy, the shekel has demonstrated consistent strength
since 2003. Israel's current account has been in surplus, and foreigners have invested record
amounts in Israel— all of which creates demand for shekels. Ironically, the Bank of Israel was
fi nally forced in 2008 to begin intervening in the currency market to prevent the shekel from
appreciating too much and making it hard for exporters to price their products competitively.
But the central bank was not setting the exchange rate as in the past. Rather, it was trying to
infl uence the market temporarily by buying dollars with shekels.
