Optimal Wage Indexation, Foreign-Exchange Intervention and Monetary Policy
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 able to choose freely an exchange rate regime can still eliminate the welfare loss by supplementing the(constrained) monetary policy with an optimal rule for wage indexation. The paper concludes with an examination of the consequences of departures from optimal policy by comparing the welfare loss resulting from the imposition of alternative constraints on the degree of wage indexation, on foreign exchange intervention and on the magnitudes of other policy feedback coefficients.
|Date of creation:||Apr 1984|
|Date of revision:|
|Publication status:||published as Aizenman, Joshua and Jacob A. Frenkel. "Optimal Wage Indexation, Foreign Exchange Intervention and Monetary Policy." American Economic Review, Vol. 75, No. 3, (June 1985), pp. 402-423.|
|Note:||ITI EFG IFM|
|Contact details of provider:|| Postal: |
Web page: http://www.nber.org
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- 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.
- Bhandari, Jagdeep S., 1982. "Staggered wage setting and exchange rate policy in an economy with capital assets," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 275-292, January.
- 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.
- Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
- Aizenman, Joshua, 1985.
"Wage Flexibility and Openness,"
The Quarterly Journal of Economics,
MIT Press, vol. 100(2), pages 539-50, May.
- 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.
- Matthew B. Canzoneri & Dale W. Henderson & Kenneth S. Rogoff, 1981.
"The information content of the interest rate and optimal monetary policy,"
International Finance Discussion Papers
192, Board of Governors of the Federal Reserve System (U.S.).
- 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, vol. 98(4), pages 545-66, November.
- 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.
- Robert P. Flood & Nancy Peregrim Marion, 1980.
"The Transmission of Disturbances under Alternative Exchange-Rate Regimeswith Optimal Indexing,"
NBER Working Papers
0500, National Bureau of Economic Research, Inc.
- 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, vol. 97(1), pages 43-66, February.
- 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.
- Frenkel, Jacob A. & Aizenman, Joshua, 1982.
"Aspects of the optimal management of exchange rates,"
Journal of International Economics,
Elsevier, vol. 13(3-4), pages 231-256, November.
- Jacob A. Frenkel & Joshua Aizenman, 1983. "Aspects of the Optimal Management of Exchange Rates," NBER Working Papers 0748, National Bureau of Economic Research, Inc.
- Barro, Robert J., 1977. "Long-term contracting, sticky prices, and monetary policy," Journal of Monetary Economics, Elsevier, vol. 3(3), pages 305-316, July.
- 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.
- Azariadis, Costas, 1978. "Escalator clauses and the allocation of cyclical risks," Journal of Economic Theory, Elsevier, vol. 18(1), pages 119-155, June.
- Fischer, Stanley, 1977. "Wage indexation and macroeconomics stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 5(1), pages 107-147, January.
- Karni, Edi, 1983. "On Optimal Wage Indexation," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 282-92, April.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:1329. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.