Ebook The Inflationary Impact of Wage Indexation
It has often been said that indexed contracts advance inflation. On one hand, wage indexation increases the slope of the Phillips curve and makes it more difficult to use monetary policy for stabilizing employment. Indexed bonds prevent that inflation depreciates the real value of government debt and indexed tax schemes decouple real revenues of a progressive income tax from inflation.
Thereby, indexation reduces the government’s gains from inflation and its incentive for expansionary monetary policy. On the other hand, indexation reduces social costs of inflation and the central bank’s resistance to inflationary policy. These two effects influence the inflation bias in opposite directions, and within the standard model of monetary policy by Barro and Gordon (1983) it is not clear under which circumstances one or the other effect dominates (Mourmouras, 1993).
Wage indexation reduces social costs of inflation because real wage stability is viewed at as being socially desirable. This paper extends the Barro–Gordon model by including costs of real wage fluctuations in the social loss function and endogenizes both, the slope of the Phillips curve and social costs associated with wage indexation. This allows a rigorous comparison of both effects and shows that wage indexation unambiguously reduces the inflation bias but may raise or lower the variance of inflation rates depending on the weight that the central bank attaches to the goal of price stability.
Wage indexation to the price level and wage adjustments to productivity are means to allocate risk stemming from real shocks and monetary policy. From Gray (1976) and Fischer (1977) we know that indexation tends to stabilize output in the case of nominal shocks, but prevents the necessary adjustments to real shocks. In Gray’s model, the optimal degree of indexation is an interior solution and corresponds to the relative importance of nominal shocks. This relies on her assumption that wage contracts cannot be conditioned on productivity measures.
As Karni (1983) laid out, indexation schemes are capable to duplicate the perfect information equilibrium if wages are indexed to a set of variables that are a sufficient statistic for exogenous shocks. In our model, wage contractors aim at minimizing a weighted average of the variances of employment and real wages. They can achieve an optimal allocation of supply side risk by indexing wages to some measure of productivity. Demand shocks can be neutralized by indexation to prices. Full indexation to the price level makes the real sector immune to monetary policy and eliminates any incentive, to pursue employment goals by inflation. Hence, the central bank concentrates on stabilizing prices and the inflation bias is zero.
In real economies, however, asymmetric information impedes optimal wage adjustments to productivity shocks. Monetary policy can act as a partial substitute for insufficient wage adjustments by responding to temporary supply shocks and smoothing the adjustment process of the real economy to permanent shocks. In the paper, it is shown that for suboptimal wage adjustments to productivity, monetary policy improves upon the allocation of supply side risk at the cost of fluctuating prices. The optimal monetary policy rule balances costs of price fluctuations with efficiency gains from stabilizing the real sector. A high degree of wage indexation hampers real effects of monetary policy on labor markets and raises the variance of inflation rates that is necessary to re–allocate risk in the real sector. Hence, wage indexation may reduce welfare, although it always lowers the inflation bias.
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