On the Absence of Positive Wage Indexation

Abstract

This paper rationalizes the absence of positive wage indexation in labour contracts-that is, of indexing provisions that link wage increases to inflation. We investigate the equilibrium of a policy game in a stochastic economy in which wage-setters and a policy-maker interact strategically in order to determine the preferred degree of wage indexation and an optimal stabilization rule, respectively. Our conclusion is that nominal wage rigidity and counterinflationary economic policy represent the best courses of action when price stability is valued and negative responses of contractual wages to price shocks are ruled out. Under these assumptions, moreover, the stochastic structure of the economy has no bearing on the optimality of maximal real wage flexibility. This paper presents an argument for explaining nominal wage rigidity in labour contracts. We investigate the equilibrium of a policy game in a stochastic economy in which wage-setters and a policy-maker interact strategically in order to determine the preferred degree of wage indexation and an optimal intervention rule, respectively. Our conclusion is that indexing provisions that maximize the flexibility of real wages and counter-inflationary economic policy represent the best courses of action for the players. In the absence of schemes that create a negative correlation between wage and price movements, maximal real wage flexibility is attainable through zero indexation or rigid nominal wages. The crucial assumption that drives this result is that some price stability is desirable for the policy-maker. The introduction of price stability as a goal seems eminently justified from a practical standpoint. The Federal Reserve System's legislative mandate from the Federal Reserve Reform Act of 1977, the ongoing debate about the House Joint Resolution 409 and the Delors Report, which speaks of an 'unequivocal commitment to maintain price stability as the primary objective of the [European] System [of Central Banks]',