Protecting households from energy shocks: wage indexation and fiscal policy

This paper evaluates the role of automatic wage indexation following an imported energy price shock in a small open economy belonging to a monetary union. We develop a two-agent New Keynesian model with energy in consumption and production and featuring Ricardian and hand-to-mouth (HtM) households. Wage indexation protects purchasing power through an income channel but impairs the competitiveness of domestic firms, reduces employment, and affects consumption through real interest rate dynamics. We show that although universal indexation mitigates the rise in inequality after an energy shock, HtM consumption benefits only partially because adverse general equilibrium effects offset some of the gain in real wages. Targeting indexation at vulnerable households alleviates the cost for firms but creates distortions in the labour market that may harm the disposable income of indexed workers. Among fiscal instruments, both wage-cost and energy-price subsidies are effective in supporting HtM consumption and reduce welfare inequalities among households. Stabilising energy prices is particularly beneficial for households with a high share of energy in their consumption, especially when a significant portion of their consumption expenditures is dedicated to essential energy needs.