However, the problem in an emerging economy with eroded policy credibility is that a policy mix with a combination of offsetting policies sends a mixed signal to the public. The public will tend to give a larger, myopic weight to the expansionary part of the policy, which will hamper policy credibility even more. The fact that inflation expectations in Israel during the years 1994 to mid 1997 were consistently higher than actual inflation indicates that market participants still perceive a latent danger for future inflationary excesses. In such a case a premature relaxation of monetary policy might therefore require an even more restrictive monetary policy in the future, to counteract the inevitable loss of confidence in monetary policy that would occur. Even with a low probability, the expected cost is high, due to the high penalty inflicted by globalization.
Stabilization is a time consuming process.
Therefore it is irresponsible to react excessively to the current observed output gap. In Israel it took the authorities about two and a half years to recognize the need for restrictive fiscal policy and implement it. Enhance the Flexibility of the Exchange Rate Regime Or - How to find a suitable exit policy. Flexibility is a sine qua non for foreign exchange markets. The shocks will eventually need to be absorbed.