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Supply Shocks, Wage Indexation and Monetary Accommodation

  • Aizenman, Joshua
  • Frenkel, Jacob A

This paper develops a unified framework for the analysis of wage indexation and monetary policy in the presence of supply shocks. We first present simple formulae for the optimal wage indexation rule and for the optimal money supply rule. In order to set the stage for an evaluation of departures from the optimal policy rules we first analyse two extreme cases -- a rule that stabilizes employment and a rule that stabilizes the real wage. The analysis of these two extreme cases provides the ingredients for the evaluation of various rules for wage indexation and for monetary targeting. We examine the implications of indexing wages to (i) nominal GNP, (ii) the CPI and (iii) the value-added price index, as well as the implications of targeting the money supply to these alternative three indicators. It is shown that, the various indexation rules bear a dual relation to the various monetary targeting rules. The welfare ranking of the various rules depends on whether the elasticity of the demand for labor exceeds or falls short of the elasticity of labor supply. If the demand for labor is more elastic than the supply, then policy rules that stabilize employment produce a smaller welfare cost than policy rules that stabilize the real wage. In that case, indexing wages to nominal GNP results in a smaller welfare cost than indexing to value-added price index which, in turn, produces a smaller cost than indexation to the CPI. Because of the dual relation between monetary policy and wage indexation, it follows that under the same circumstances, monetary policy that targets nominal GNP produces a smaller welfare cost than policy that targets the value-added price index which, in turn, results in a smaller cost than the policy that targets the CPI. This ranking is reversed when the elasticity of the supply of labor exceeds the elasticity of demand.

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Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 18 (1986)
Issue (Month): 3 (August)
Pages: 304-22

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Handle: RePEc:mcb:jmoncb:v:18:y:1986:i:3:p:304-22
Contact details of provider: Web page: http://www.blackwellpublishing.com/journal.asp?ref=0022-2879

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  1. Blinder, Alan S, 1981. "Monetary Accommodation of Supply Shocks under Rational Expectations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 13(4), pages 425-38, November.
  2. Benjamin Eden, 1979. "The Nominal System : Linkage to the Quantity of Money or to Nominal Income," Revue Économique, Programme National Persée, vol. 30(1), pages 121-143.
  3. Bean, Charles R, 1983. "Targeting Nominal Income: An Appraisal," Economic Journal, Royal Economic Society, vol. 93(372), pages 806-19, December.
  4. Barro, Robert J., 1977. "Long-term contracting, sticky prices, and monetary policy," Journal of Monetary Economics, Elsevier, vol. 3(3), pages 305-316, July.
  5. Aizenman, Joshua & Frenkel, Jacob A, 1985. "Optimal Wage Indexation, Foreign Exchange Intervention, and Monetary Policy," American Economic Review, American Economic Association, vol. 75(3), pages 402-23, June.
  6. Karni, Edi, 1983. "On Optimal Wage Indexation," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 282-92, April.
  7. Nancy Peregrim Marion & Lars E.O. Svensson, 1982. "Adjustment to Expected and Unexpected Oil Price Changes," NBER Working Papers 0997, National Bureau of Economic Research, Inc.
  8. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
  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. Fischer, Stanley, 1977. "Wage indexation and macroeconomics stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 5(1), pages 107-147, January.
  11. Ronald E. Findlay & Carlos Alfredo Rodriguez, 1977. "Intermediate Imports and Macroeconomic Policy under Flexible Exchange Rates," Canadian Journal of Economics, Canadian Economics Association, vol. 10(2), pages 208-17, May.
  12. Cukierman, Alex, 1980. "The effects of wage indexation on macroeconomic fluctuations : A generalization," Journal of Monetary Economics, Elsevier, vol. 6(2), pages 147-170, April.
  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, vol. 20(1), pages 83-103, February.
  14. Robert J. Gordon, 1975. "Alternative Responses of Policy to External Supply Shocks," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 6(1), pages 183-206.
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