Discretion, Wage Indexation, and Inflation

Abstract

It is now well understood that discretionary policy-making frequently leads to socially sub-optimal outcomes. This point was first made by Kydland and Prescott [12] using an example of a monetary policy game. They argued that, in the presence of output distortions in the economy, the monetary authority has an incentive to renege on earlier promises to maintain price stability by expanding the money supply in order to create unexpected inflation, thereby increasing output and employment. Since private wage setters form expectations rationally, this policy action is anticipated and, in equilibrium, leads to excessive inflation without any resulting change in output or employment. Consequently, in the absence of enforceable policy rules, the time-consistent discretionary monetary path produces a socially sub-optimal inflation rate. This form of policy behavior has important implications for the decisions of private agents, such as their choice of the degree of wage indexation. However, most work in the literature on endogenous wage indexation, stemming from the seminal paper by Gray [10], has analyzed the equilibrium indexation choice assuming either a constant money growth rule [1] or a monetary rule involving lagged or contemporaneous feedback [8; 17]. Only the recent papers by Devereux [5; 6] have attempted to examine the implications of time-consistent discretionary monetary policy for endogenous wage indexation. The informational structure he considers has the monetary authority setting the money stock prior to the realization of shocks, so that the authority has no information regarding current period disturbances when determining its course of action. This assumption precludes any contemporaneous attempt by the monetary authority to stabilize output or the price level. Devereux reaches the conclusion that wage setters, who are aware of the authority's policy decision, will find it optimal to index positively to unanticipated price level surprises, since none of the aggregate shocks are offset directly by the monetary authority. Thus, the informational environment confronting the authority influences the degree of indexation and, subsequently, the manner in which aggregate demand and supply variability impinge upon social welfare.