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Optimal Wage Indexation, Foreign Exchange Intervention, and Monetary Policy

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  • Aizenman, Joshua
  • Frenkel, Jacob A

Abstract

This paper deals with the design of optimal monetary policy and with the interaction between the optimal degrees of wage indexation and foreign exchange intervention. The model is governed by the characteristics of the stochastic shocks which affect the economy and by the information set that individuals possess. Because of cost of negotiations, nominal wages are assumed to be precontracted and wage adjustments follow a simple indexation rule that links wage changes to observed changes in price. The use of the price level as the only indicator for wage adjustments may not permit an efficient use of available information and, may result in welfare loss. The analysis specifies the optimal set of feedback rules that should govern policy aiming at the minimization of the welfare loss. These feedback rules determine the optimal response of monetary policy to changes in exchange rates, interest rates and foreign prices. The adoption of the optimal set of feedback rules results in the complete elimination of the welfare cost arising from the simple indexation rule and from the existence of nominal contracts. Since optimal policies succeed in the elimination of the distortions, issues concerning the nature of contracts and the implications of specific assumptions about disequilibrium positions become inconsequential. The analysis then proceeds to examine the interdependence between the optimal feedback rules and the optimal degree of wage indexation. It is shown that a rise in the degree of exchange rate flexibility raises the optimal degree of wage indexation. One of the key conclusions is the proposition that the number of independent feedback rules that govern a policy must equal the number of independent sources of information that influence the determination of the undistorted equilibrium. Thus, it is shown that with a sufficient number of feedback rules for monetary policy there may be no need to introduce wage indexation. It is also shown that an economy that is not

(This abstract was borrowed from another version of this item.)

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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 75 (1985)
Issue (Month): 3 (June)
Pages: 402-23

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Handle: RePEc:aea:aecrev:v:75:y:1985:i:3:p:402-23

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  1. Richard C. Marston, 1981. "Wages, Relative Prices, and the Choice between Fixed and Flexible Exchange Rates," NBER Working Papers 0793, National Bureau of Economic Research, Inc.
  2. Harberger, Arnold C, 1971. "Three Basic Postulates for Applied Welfare Economics: An Interpretive Essay," Journal of Economic Literature, American Economic Association, vol. 9(3), pages 785-97, September.
  3. Fischer, Stanley, 1977. "Wage indexation and macroeconomics stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 5(1), pages 107-147, January.
  4. Jacob A. Frenkel & Joshua Aizenman, 1983. "Aspects of the Optimal Management of Exchange Rates," NBER Working Papers 0748, National Bureau of Economic Research, Inc.
  5. Canzoneri, Matthew B & Henderson, Dale W & Rogoff, Kenneth S, 1983. "The Information Content of the Interest Rate and Optimal Monetary Policy," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 98(4), pages 545-66, November.
  6. Frenkel, Jacob A. & Razin, Assaf, 1980. "Stochastic prices and tests of efficiency of foreign exchange markets," Economics Letters, Elsevier, vol. 6(2), pages 165-170.
  7. Flood, Robert P & Marion, Nancy Peregrim, 1982. "The Transmission of Disturbances under Alternative Exchange-Rate Regimes with Optimal Indexing," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 97(1), pages 43-66, February.
  8. Bhandari, Jagdeep S., 1982. "Staggered wage setting and exchange rate policy in an economy with capital assets," Journal of International Money and Finance, Elsevier, Elsevier, vol. 1(1), pages 275-292, January.
  9. Azariadis, Costas, 1978. "Escalator clauses and the allocation of cyclical risks," Journal of Economic Theory, Elsevier, vol. 18(1), pages 119-155, June.
  10. Joshua Aizenman, 1983. "Wage Flexibility and Openness," NBER Working Papers 1108, National Bureau of Economic Research, Inc.
  11. Cukierman, Alex, 1980. "The effects of wage indexation on macroeconomic fluctuations : A generalization," Journal of Monetary Economics, Elsevier, Elsevier, vol. 6(2), pages 147-170, April.
  12. Barro, Robert J., 1977. "Long-term contracting, sticky prices, and monetary policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 3(3), pages 305-316, July.
  13. Calvo, Guillermo A, 1979. "On Models of Money and Perfect Foresight," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 20(1), pages 83-103, February.
  14. Richard C. Marston, 1982. "Wages, Relative Prices and the Choice between Fixed and Flexible Exchange Rates," Canadian Journal of Economics, Canadian Economics Association, vol. 15(1), pages 87-103, February.
  15. Karni, Edi, 1983. "On Optimal Wage Indexation," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(2), pages 282-92, April.
  16. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, Elsevier, vol. 2(2), pages 221-235, April.
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