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United States reduced the demand for Chilean goods. To limit any drain on its foreign exchange reserves, the Central Bank of Chile adopted a restrictive monetary policy. In order for economic growth to have continued, nominal prices and wages would have had to decline drastically, and they were not sufficiently flexible to do so.* Indeed, they continued to rise, propelled partly by backward-looking indexation. As a result, Chile was thrown into a major recession, far more severe than the recession in the United States: real output fell by 14 percent in 1982 and another 1 percent in 1983 (see Figure 1).

The political and economic pressure forced the resignation in 1982 of Sergio de Castro, the minister of finance who had made the decision to peg the exchange rate. The peg was abandoned in August 1982 and the peso permitted to depreciate in terms of the U.S. dollar. The adverse effects continued into 1983, but by 1984 the economy was growing again, at an annual rate of 6 percent.

Even if Chile had not pegged the peso to the dollar, it nonetheless would have experienced a recession, in company with much of the rest of the world and because of the changes in the prices of oil and copper. However, the recession would have been far less severe. Chile paid a high price for its experiment of pegging the peso.

Israel

Chile pegged its currency to the U.S. dollar after the country had successfully reduced inflation from high triple digits to low double digits. It did so as what it hoped would be the final step in curbing the inflation.

Israel pegged its currency to the U.S. dollar as part of an initial reform designed to curb inflation. Israel's inflation was at an annual rate of about 500 percent in the second quarter of 1985, just prior to the implementation of this 1985 economic stabilization program. The main features of the program were: "a 20% devaluation of the shekel vis-a-vis the dollar and the pegging of a new rate at this level; a substantial reduction in the budget deficit involving mainly a cut in subsidies. A temporary wage and price freeze was to function as the income policies complement" (Barkai 1990a, [>]). The muscle to enforce the policy was a "very tight monetary policy...[which] did what it was expected to do: to act as a stopgap and allow the restrictive fiscal policy ... to come into its own, and correspondingly, allow fiscal absorption to sustain the downward pressure on liquidity" (Barkai 1990a, p. 151). In these respects, the Israeli reform closely paralleled the initial steps taken by Chile to curb its hyperinflation in 1975.

The major difference was that the Israeli reform included the pegging of the currency and a temporary freeze on wages and prices, steps intended to add credibility to the government's intention to bring down inflation and thereby ease the transition to a lower rate of inflation. The reform was spectacularly successful. Inflation fell from an annual rate of 500 percent in the second quarter of 1985 to a rate of 18 percent in the first two quarters of 1986 and 20 percent for 1986 as a whole. Inflation has since remained around 15 percent to 20 percent (Barkai 1987; Bruno and Meridor 1990).* There was a significant, though only moderately severe, economic slowdown in reaction to the re-form. The slowdown was brief and was followed by a rapid recovery in 1986–87. Then, however, there was a delayed reaction in the form of a more severe recession lasting two years (Bruno and Meridor 1990).

Pegging the shekel to the dollar contributed to the success of Israel's reform because two of the developments that had doomed the Chilean peg were, by happy chance for Israel, reversed. The dollar peaked in foreign exchange value in early 1985 and then depreciated from 1985 to 1990 by about as much as it had appreciated from 1980 to 1985. In addition, the price of oil, which peaked in terms of dollars in 1981 and fell gradually until 1985, plummeted in 1985. The depreciation of the dollar meant that the shekel, too, depreciated vis-a-vis other currencies, encouraging exports and discouraging