Among the free world's ministers of finance, Israel's Yitzhak Modai may have the toughest assignment: It is his responsibility to deal with an economic crisis symbolized by an inflation rate that has -- with the help of a fully indexed economy -- exceeded 1,000 percent annually.

But Modai, who was here last week to help negotiate Israel's biggest-ever request for American aid, displayed in an interview the kind of optimism that has enabled Israel to fend off hostile neighbors and still scratch a democratic oasis out of the desert.

Faced with Israeli requests for $800 million in emergency assistance for fiscal 1985, on top of $2.6 billion for military and economic aid already being supplied, and $4.05 billion planned for fiscal 1986, the Reagan administration for the first time has found it necessary to place economic conditions on its aid to a foreign country, despite the "special relationship" with Israel.

For Israel, this will pose a severe test: it's not easy to advocate a policy that clearly means higher unemployment.

Chomping on a cigar in the best Paul Volcker style, Modai said that the embattled Israelis "have come to the realization that we are the only ones who can cure our own economy, and that we have no alternative but to take the necessary measures."

But what measures? So far, the Israeli government hasn't been able or willing to take the extremely tough anti-inflation steps pushed by the United States, although friends warn that it's best to face the music.

But Israel, like other heavily indebted nations, knows this is easy advice for outsiders to give and hard for governments to enforce and still stay in office. The jobless rate in Israel is now 5.8 percent, and will rise in "a planned manner this year to 7.4 percent, which is what we feel is the maximum that Israel can take," according to Dan Halperin, economic minister at the Israeli Embassy.

Israel's economic crisis stems from the financial drain of the 1973 war, which put an end to 18 consecutive years of real economic growth gains of between 9 and 10 percent. Last year, the Israeli real growth rate was zero, and it would have been a minus had it not been for exports. Piled on top of the $12 billion cost of the 1973 war were the two oil shocks (1973-74 and 1979-80), which quadrupled oil prices.

What's more, much of the extraordinary aid from the United States, starting after the Six-Day War of 1967 and until a few years ago, was in the form of loans, not grants. Fully one-third of Israel's burdensome $23 billion foreign debt was borrowed to buy weapons in the United States -- and the annual servicing cost runs to $1.1 billion.

Modai, a member of the Likud Party, knows that the Israeli standard of living must be cut back. But as a successful politician, he also knows that there are social and political limits to the ability of the five-month-old unity government under Prime Minister Shimon Peres to take the kind of austerity steps recommended by the United States.

Modai argues that the new government has already accomplished much to put Israel's economic house in order through temporary wage and price controls and $1.5 billion in budget cuts, including slashes in government subsidies for basic consumer products. He pointed to a new law going through the Israeli parliament that will make it an offense punishable by loss of job or pension for public employees, including ministers, to exceed allowable budget expenditures. A second law to be presented shortly by the Peres government will give independence to the central bank in establishing the overall monetary policy.

But without basic changes in the indexation scheme, inflation will stay at the 900 to 1,000 percent levels. State Department officials and a working group of private economists look for fundamental changes: a bigger slash in the budget and a willingness to squeeze consumer demand even more.

But the Israelis look for a bigger pie rather than smaller portions. The basic economic solution for Israel, Modai insists, is for a return to growth in the 6-7 percent range, stimulated by a 10 percent annual growth rate of exports, especially high-tech goods, and a new and historic free-trade agreement with the United States.

Who is to tell the ingenious Israelis that it's impossible? Modai insists that it can be done, even if peace is elusive, requiring maintenance of a huge defense budget: "In general if we have a peaceful time, it's good for the nerves, it's good for the planning, it's good for everything. But it's the one thing we cannot guarantee."