Wage Indexation and the Time Consistency

It has long been recognized that contemporaneous wage indexation stabilizes output and employment in the face of monetary shocks, but hampers the adjustment of the economy to real shocks that require changes in the real wage. Another feature of wage indexing is that it reduces the incentive of the government to raise output through unexpected inflation, since wages react automatically to prices. In this paper I construct a simple model where the decision on the degree of wage indexation is not taken by atomistic agents, but by a "large" agent such as the government. Under this assumption I show that the optimal degree of indexing depends not only on the variance of real shocks, but also on the "inflation bias" of the government, due to the incentive to raise employment above the market-clearing level. In particular the model predicts that wage indexation will be low not only if real shocks are large, but also if the government is inflation-averse. The ability of monetary policy to offset monetary disturbances makes them irrelevant to the determination of the optimal degree of indexing.