Indexation and Inflationary Inertia: Brazil 1964–1985

Abstract

Some governments facing high rates of inflation have adopted wage and exchange rate indexation in an attempt to offset the costs to workers and exporters. But indexation based on past values of inflation is considered to be a powerful source of current and future inflation that undermines fiscal and monetary stringency designed to reduce inflation. Brazil indexed wages and the exchange rate for more than twenty years. The authors derive a transfer function and estimate time-varying parameters to allow for the changes in indexing policy over the period. The authors find that the increased frequency of wage and exchange rate adjustment amplified the effect of past inflation and made it less sensitive to monetary and fiscal policies and more vulnerable to domestic agricultural supply shocks. Indexing did not eliminate the effectiveness of monetary policy, however, which retained a significant effect throughout the indexation period.