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Monetary Integration Between the Israeli,Jordanian and Palestinian Economies
Arie Arnon* and Avia Spivak"
DiscussionPaper No. 95.11
December 1995
An early versionofthis paperwas presented at the conference "Sustaining Peace inthe Middle East through Economic Cooperation" , Amsterdam, October 1994.
We would like to thank the participants in the conference for theircomments andLaurenceHarris, Raif Melnick, Daniel Gottlieb and Momi Dahan for helpfulsuggestions. SOAS provided an extremely productive environment forwriting theifrst draft ofthis paper. All errors and omissions remain ours.
he views expressed inthispaperare those oftheauthors anddonot necessarilyflect those ofthe institutions with which they are affiliated.
*Department ofEconomics and MonasterCenterfor Economic Research, Ben-GurionUniversityofthe Negev,d Research Department, the Bank ofIsrael.
"DepartmentofEconomics and MonasterCenter forEconomicResearch, Ben-GurionUniversityofthe Negev,rael.
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ABSTRACT November, 1995
MONETARY INTEGRATION BETWEENTHE ISRAELI, JORDANIAN AND
PALESTINIAN ECONOMIES
Arie ARNON* and AviaSPIVAK"
The peace process betweenIsrael and the Palestinians raises some interesting economic
questions concerning integration between the West Bank, Gaza and Israel. In this paper we
describe past and current arrangements between Israel, the occupied territories and Jordan,
focusing particularly on trade and labour lfows. We then compare the similarity ofeconomic
performance of the four regions, employing recent developments in the statistical analysis of
macroeconomic data due to Blanchard and Quah (1989), which enable to extract the shocks to
the economies. Ourfindings indicate that underthe pastandcurrent economic relations, Israel,
the West Bank and Gaza were closely integrated, whereas economic integration between the
occupied territories and Jordan was much weaker. Based on these past circumstances, the
(imposed) monetary union between Israel and the Palestinian Economy was warranted.
However, optimal monetary arrangements in thefuturewill depend on the extentofchanges in
real flows andon a satisfactory settlementof the seigniorage issue.
JEL Classification: E42, Oil, O53
* DepartmentofEconomics andMonaster Center forEconomic Research, Ben-GurionUniversityofthe Negev.andResearch Department, the BankofIsrael.
" Department ofEconomics and Monaster Center for Economic Research, Ben-Gurion Universityofthe Negev,Israel.
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Moneatry Integrnlion 1
I. Introduction
The peaceprocess between Israel and the Palestinians raises some interesting
economic questions. Is the existing monetary union between the West Bank, Gazaand
Israel optimal? Should it be continued in theemerging new political and economic
environment?
Ouraim in this paper is to study the past and the present for the lessons thatcan
be drawn for the future, butalso for its own sake. Clearly, the monetary union is the
outcomeofwar and occupation and not offree negotiations. Hence, its optimality to the
WestBankand Gaza, is suspected. Hamed and Shaban (1993) hint thatIsrael imposed the
currency union to collect seigniorage from the Palestinians. While the seigniorage point is
well taken thereare other important costs and benefits of monetary unions.1
The benefits from a monetary union are that transactions can be made more
efficiently, since one money is used as aunit ofaccount and medium ofexchange.
Having several monies is cumbersome, and introduces uncertainty and transaction costs.
These benefits ofa common currency increase with the volumeoftrade between the
economies.
The costs ofa monetary union are associated with the loss ofan independent
monetary policy. Robert Mundell who initiated the modern discussionofoptimal currency
areas (OCA), consideredachange ofdemand which is an external shock to the economy
thatcan be accommodated with the appropiratemonetary policy (Mundell, 1961). In a
common currency regime, there might be a loss ofoutput due tothelengthyadjustment
process. Alternatively, if two countires are subject to the same shocks and theirstructure
is similar, then they will use the same monetarypolicy even without a monetary union,
' For anotherattempt to assess the seigniorage see Arnon and Spivak (1995(.
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Mdnetaiy Inetgartion 2
hence there is no cost to a monetary union undersuch condiitons.
Mundell mentioned anothercriterion for monetary integration: iflabourand other
factorsofproducitonare mobilebetween two regions, then acommon monetary policy
can be used even ifthe regions are subject to different shocks, because the movementof
labourwill restore equilibrium.
In a reaction to Mundell, McKinnon (1963) emphasised thedangersof
independent currencies with flexibleexchange rates. Thearguments raised by McKinnon
seem very relevant forthe MiddleEast countires. Hecontends that small open countires
cannot use monetary policy (i.e. devaluaiton) to foster employment because the
depreciaitonofthe currency is translated into inflation, and has no real effects. Israel's
inflaiton is a classic example ofsuch mechanism.
Thus, the benefits and costs ofalternaitve monetary arrangements depend on the
openness ofthe different regions vis-a-vis theothers their level ofintegraiton, and in
paritcularhow free is the movement ofthe factors ofproduciton the similairtyofthe
economies' structures and thecorrelaiton ofthe external shocks that they face.
The rest ofthe paperinvesitgates these topics. In Seciton II we descirbe the trade
and labourmovements and exisitng arrangements between Israel, theoccupied terirtoires
and Jordan, including the recent Pairs Protocol onEconomic Relaitons (1994) which has
shaped thecurrent 'interim phase' officially in effect unitl 1999.2 It will provide the
evidencenecessary to evaluate the monetary union under the present situaiton as well as
the background forfuture arrangements.
In seciton III westudy the similairty ofeconomicperformance ofthe four regions.
Wewill use theterms West Bank and Gaza, theoccupiedterritoires, the Palestinianeconomyand the Areas
interchangeably.
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Moneatry Integartion 3
We elaborate on this issue in seciton IV where we employ recent developments in the
statistical analysis of macroeconomic data due to Blanchard and Quah (1989). This
analysis uncovers the underlying exogenous shocks to the economy which give irse to the
observed time seires of majormacroeconomic vairables such as outputgrowth,
unemploymentand inflation. The shocks of the more permanent nature are also called,
"supply" shocks and the transitory shocks are also called "demand" shocks. This isdue to
a cirtical assumption thatonly supply shocks havea lasting effect on output. We then
compare the shocks in thevarious economies in order to determine how similar they are.
The current paper is in line with similarworkof recent authors, who assessed the
desirabilityofa monetary union in the NAFTA (North Ameircan Free Trade Agreements)
countires and in Europe and Asia (see Bayoumi-Eichengreen , 1994a and 1994b). They
conclude that there is no case fora common currency in NAFTA, since NAFTA in
compairson with the EU, is exposed to more diverse shocks. As to Europe itself they
argue thata clearDM block exists, where one currency mightbe the optimal solution.
Ourown findings suggest that under the pastand presenteconomic relationship,
Israel, theWest Bankand Gazawereclosely integrated. On the otherhand, the Israeli
Shekel performance as a stable currency was farfrom satisfactory. Togetherwith the
Israeli currency the Palestinians received inflation, picking up to more than400 ?6 in
1984. As for the future, the expected political transformation will causechanges in the
trade patterns between the Palestinians and Israel, Jordan and other countires. The
expected decline oftrade with Israel, in addition to the yet unresolved issue concerning
seigniorage, pointto the need toreconsider the exisitng insittutional setup.
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Monetary Integration 4
n. TheEconomicRelationship 1967-1994
This section presents the institutional arrangements which determined the economic
relations between Israel (I), the West Bank (W) and Gaza (G), andJordan (J). We
descirbe both the pre-1993 setup and the evolving new conditions, as of 1994 and on.
First, we will look at measures foropenness ofthe regions and their trade
linkages. In Table 1 we present total exports and imports as ratiosofGDP, as well as the
trade structure betweenthefour regions.
Table 1of GDPand Imports asRatioInter-regionalExports
fromJofwhich:
from IIm\GDP
tojofwhich:
to IEx\GDP
>
0.040.610.720.090.130.23
1968-77:
W0.030.901.030.060.160.33G
NA~0.57NA~0.32I
-NA0.57-NA0.20J
1978-87:
0.010.570.650.090.140.24w01.191.310.080.350.45G
NA-0.60NA-0.42I
NA0.79NA0.36J
Clearly, both W and G are very open to trade and theirmajortrading partner is
Israel. Gaza, which is smaller than W, is more open to trade. Note, however, that there
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Monetuy Integartion . 5
is more trade between the West Bankand Jordan than between Gazaand Jordan. Thus,
thetradebalance deficit reported in Table 1 is covered by the remittances ofPalestinian
workers in Israel.
Table 2
Work inand Gaza whoEmployeesResidents ofthe West Bank
TotalIsrael As Percent of
Employedofthe region
TotalPersons
Total Employeesofthe Region
GWW G
2096179S519S 39961970-1972
357028969896 1069&1973-1977
43963O9&10296 1839S1978-1987
The increasing importance ofwork in Israel and the high mobility oflabourare evident.
The smallereconomy ofGaza is even more dependenton Israel than the West Bank.
Over theyears thelabour markets for Palestinian wage earners were closely related.3
Since 1967 a forced customs union existed between Israel and the Areas.
Movementofindustrial goods was relatively free, though some important administrative
restirctionsprevented Palestinians from setting up factoires and selling theirgoods in
Israel4. Restirctions were even tougheron agircultural goods.
3 Arnon and Gottlieb [1993] also show thatwages forPalestinian workers in Israel and in the Areas moved
together in most ofthe period.
4 An important instrument in preventingcompetitionfrom'Palestinian goods was the useofqualitycontrol.
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Monetary lotcgarlioo C.
The movementoflabour rfom the Areas to Israel was monitored by Israel, and
was subject to security considerations, though duirng 1967-1987 there was practically free
entry for labourers. Concerning capital movements, both from Israel to the WB 8c G and
from the world in large, they were very limited throughout the period, due to economic
conditions in theAreas and some forms ofadministrative restirctions. Capital movements
between the Areas and Jordan were somewhat freer, apparently due to theclose
connections linking the two banks ofthe Jordan River.
The monetary system in theAreas was a dual currencyunion. Both Israeli and
Jordaniancurrencies were used in the Areas. TheJD was a legal tenderonly in the West
Bankand the Shekel was a legal tender in both the West Bankand Gaza. However, the
JD was not used in Israel and the Shekel was not used in Jordan. The exchange rate
between the Shekel and the JD was determined indirectly in the international currency
market. The banking system was underdeveloped few Israeli banks functioned in the
Areas, dealing with the Israelis living in the Areas and, to some extentwith Palestinians.
Theiractivity in intermediation was very limited. All existing banks were closed in 1967
the first to reopen was the BankofPalestine in Gaza in 1981, and the second, more
importantone, the Cairo-Amman bank in the West Bank, in 1986.5
The inteirm agreement between Israel and the PLO which provides theagenda for
the coming fiveyears includes a part on theeconomic dimensions. These were agreed
upon in the Protocol on Economic Relation which was signed in Pairs on Apirl 29, 1994
(See: Protocol, 1994). The Protocol deserves a close reading since it supposedly reflects
In April 1994 the ifrstbranchoftheBankofJordan was reopened in Ramalla. Since then, The Arab Bank,
The Jordan GulfBank, The Commercial BankofPalestine and the Arab Land Bank started operations in theterirtories. Asofthe endof1994, close to twenty bankbranchesofall the above-mentioned banks combined areactivein the West Bank half ofthem belong to the Cairo-Amman Bank.
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Monetary Integartion
the new economic conditions which will soon rule the Areas.
The interim agreement states thatexcept fora list ofseveral goods, limited in
quantities, "theIsraeli rates ofcustoms ... shall serve as the minimum basis for the
Palestinian Authority". (ArticleIll 5a). VAT will be 15 to 16 percent, similar to Israel's
current rateof 17 percent. As to the flow ofgoods between the Areas and Israel, "There
willbe free movements ofindustrial goods free ofany restriction between the two sides,
subject to each side legislation". (ArticleIX, 1). As foragricultural products, a special
arrangement restricts the exports ofifve goods to Israel specifying quotas that will
disappear gradually within ifve years.
The extent oflabour movement from the West Bankand Gazato Israel will be
determined by both Israel and the Palestinian authorities. Similarrestrictions applies to
movement in the other direction. There are no speciifed restrictions on capital
movements.
The Israeli and Jordanian currencies will continue to circulate in the Areas. Both
currencies will be legal tenders in both the W and in G. The issue ofan independent
Palestinian currency was deferred for later negotiations.
A Palestinian Monetary Authority (PMA) willbe established, having all the
functions ofa central bank, except for the issuing ofa Palestinian currency. The
functions ofthe PMA include: licensing and supervision ofbanks,supervisionof foreign '
exchange transactions and lending oflast resort. It will also be responsible for the
determination ofthe reserve ratio imposed on the banks6, and for the operation of"a
discount window and the supply oftemporary ifnance for banks operating in the Areas".
Thus, the PMA will facilitate the developmentofa banking system in the Areas.
' However, the reserve ratio forNIS depositscannotdeviate from thatoftheBankofIsrael. See article IV, 1lb.
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Monetary Integration g
Though, as stated above, the issue ofcapital movements was not mentioned
explicitly in the Protocol, itwas agreed that "the Palestinian authoirty will have the
authoirties, powers, and responsibilities regarding the regulation and supervision of
capital activities in the Areas" (ArticleIV 21).
We see that the protocol legitimizes thecustoms union, labourmovement and
monetary union between Israel and the Palestinian economy. Oursummary indicates that
the degree ofintegration between Israel and the Areas is somewhat an inteirm case
between the European Union and NAFTA. In the EU, there is free movement of
commodities, labourand capital. There is yet no common currency. In NAFTA, there is
free movement ofgoods and capital, but restircted movement oflabour each participant
in NAFTA retains its own currency and monetary authoirty. Between Israel and the
Areas, there is almost free movement ofgoods, a substantial movement oflabour, very
limited movement ofcapital the Israeli NIS is a circulating currency. Between Israel and
Jordan there is verylittle. economic relationship. Between theWB&G and Jordan there
are restirctions on the movement ofgoods and oflabour, there is almost free movement
ofcapital and theJordanian Dinar is also a circulating currency in the West Bankand
Gaza.
HI. How SimilarWerePastPerformances?
The return ofthe optimum currency areas literature duirng the last few years is
related to the new wave ofeconomic integration as reflected in the irse of the EEC and
then the EU, and the creation ofNAFTA and otherFree Trade agreements. (See e.g.
Masson-Taylor 1992, Bean 1992, Bayoumi-Eichengreen 1994a, 1994b). The basic
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Monetary Intcgnitioo Q
*considerations remain the sameas in the oirginal contribution of the 60s. On the one
hand the degree ofeconomic integration, as manifested by the amountofrestrictions on
the flows ofcapital and labour, and on theotherhand the degreeofthe resemblance of
the shocks to the economies. These factors determine whether it will be worthwhile to
have one currency or more. If the economies haverelatively 'open' borders and are
facing the same shocks they should have the same currency. Ifthey are relatively
'closed' and facedifferent shocks they should have different currencies.
Assessing the uniformityofa region, compirsed ofseveral economies, is not a
simple task. Traditionally researchers looked atthe growth rates ofGDP and thelevelsof
inflationin the vairous regions.7 However, though onecan learn from such a
compairson, and wewill present some results below, past performances mightnet 'prove'
thecase for, oragainst, onecurrency and one monetary policy. Past performances might
bethe result of, at least, two types ofcauses. Oneis best represented by the case where
differentperformances are the outcome ofthedifferent structures ofthe economies which
compirse thearea under discussion. The other refers to thecase wheredifferent external
shocks to the different economies are to be 'blamed' for the manifested vairation in
performance. In both cases adoptionofdifferent monetary policies inthevairous regions
could increase welfare. :
Due to theworkdone byBlanchard and Quah (1989) we can distinguish between
the performance and its possible causes. From the data wecomputethe probable
transitory andpermanent shocks whichresulted in the actual performance ofthe
economy. These will be used in turn to assess howcorrelated are the shocks between the
7 Comparing the basic levelsofimportant inacroeconomicvairables should notbeneglected,however, since
the aim is to evaluate the advantagesof having monetary policy, the focus here is more about changes in theeconomies than about theirrelative size.
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Moneatry Inetgartion JQ
different regions. The method was used, with some modification, by Bayoumi and
Eichengreen (1994a, 1994b) in the context ofmonetary integration. Their interest was
the NAFTA arrangement and whether it meets thecriteira fora common currency area.
Their findings led them to conclude that since the shocks to the NAFTA countries were
more diversified than those to theEU, it is lessrecommendedthat NAFTA will moveto
a monetary integration.
Let us first examine the relativeperformances ofthe four regions, trying to
establish whether there are significant comovements in the majorvariables. The data
which we evaluateare theannual growth rates ofGDP and the rates ofinflation in Israel
(I), Jordan (J), theWest Bank (W) and the GazaStrip (G) from 1968 to 1992. The price
data for the West Bankand Gazais denominated in Shekels. We used GDP data and not
GNP, since it does not include remittances forlabour in Israel and thus represents better
the real economies. The period covers thepost-1967 waryears, forwhich we have
reliable figures.
Table 3
Correlations Between Inlfation rates 1968-1992
API APJ APW
API
-0.209APJ
0.997-APW
0.994-APG
-0.212
-0.197 0.998-
'Signiifcant at the 1% level.
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Monetary Integariton J J
Table 3 clearly documents the close associaiton between inlfation rates in I, W and
G. In this case it is not difficult to conclude thatthe Israeli inlfationprocess lead its way
to the other two economies. This relfects again the strong trade linkages between I, W
and G and the mobilityoflabor shown in Tables 1 and 2. While smallerand insignificant
even at the5% level, the negaitve correlaitons between I and J and between J and, both
W and G, might seem surprising at ifrst look. However, at a second thought the negaitve
relaitonship apparently relfects the basic differences in the itming of stabilisaiton policies
in the two economies. Jordan managed to reduce the inlfaiton rates in theearly 80's, just
whenIsrael5 s inlfation accelerated. These were the years ofthe post second oil shock.
The opposite was true for the years 1973-1974. The negative correlaitonbetween J and
WefG are a relfeciton ofthe I-J negaitve correlaiton.
The correlaitons between GDP1s growth rates tella different story (seeTable 4).
First, thecorrelations are smaller. Secondly, I and both W and G arepositively related
and Gaza is not related to the West Bank. Jordan is posiitvely related to W and negaitvely
to G. Theses ifndings indicate the stronger ites between Wand J, whereas different forces
are at work in theGazan economy. (See also Table I).8
8 The data include the years ofthe Intifada. Excluding those years (1988-1992) does not alter the above
description.
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Mondary Inetgration 19
Table 4
Correlations Between Growth rates of GDP 196SM992
AYI AYJ AYW
AYI
AYJ -0.182
AYW 0.278 0.257
AYG 0.280 -0.220 -0.002
All Correlations are insignificant at the 1096 level.
The data, so far, suggest that there is more then one family ofeconomies in our sample.
Jordan's economy was notbehaving as ifit was part ofthe same family ofeconomies as Israel,
whereas the West Bankseems to be associated with the Israeli economy concerning inflation and
with both Israel and Jordan concerningGDP's growth rates. The Gazan economy is almost
similar to the West Bankconcerning inflation, but very different from the Jordanian economy
with regards to real growth rates. Indeed the structure ofthe Gazan economy is different: Itis
more dependenton outsidejobs for its labour, it is less industiralised, its population growth is
higher, and its standards oflivingare lower than in the West Bank.
It is interestingto. compare the orderofmagnitude ofthe correlations in theMiddle East
to that ofNorth America. The 0.99 inflation correlations found between Israel, the WB and G is
similar to that found within theUS between New England and California, orwithin Canada.
(Bayoumi-Eichengreen, 1994a). As for theother geographic regions reported in Bayoumi-
Eichengreen (1994b) the correlations are much lower. Apparently, a common currency is a
necessary but not sufficient condition forsuch degree ofprice similarity. Thecorrelations
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McoeotiyIntegartion 23
between Canada and US are lower, and so. areall those reportedin Bayoumi and Eichengreen
(1994b). However, within the US, correlation between the South Westand the Plains is 0.85 (see
Table 8 in Bayoumi-Eichengreen , 1994a and Table 8 in 1994b).
Output changes' correlations are lower than the pirce correlations for the North Ameircan
regions. But the within country correlations range from 0.44 to 0.94, larger then all ourpositive
correlations. Mexico's correlation with theSouth West is 0.62, pointing to more integration than
Israel and W&G.
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MoncUiy Integnitkx) 14
IV. Identifyingthe Transitoryand PermanentShocks
The procedure used to identify the shocks to thevarious economies was proposed by
Blanchard Sc Quah (1989) and extended to inflation rates and real growth rates by Bayoumi
(1992). The procedure which is described in the appendix wasapplied to various cases by
Bayoumi and Eichengreen (1994a, 1994b).
Using this method we computed theshocks to the foureconomies. In table 5 wepresent
the correlation between the transitory shocks and in Table6between thepermanent shocks.
Table 5
Correlation between Transitory Shocks in Israel (I),Jordan (J), West Bank (W)and Gaza (G), 1969-1992
W
-I
--0.265J
-0.1170.595-w
0.0340.112G 0.041
Significantatthe /g level.
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MoaeatfyIntegartion \