The Implications of Wage Indexation on the Magnitude of Macroeconomic Fluctuations in a Simple Closed Economy

Abstract

This article re-examines the issue of whether wage indexation may or may not accentuate the fluctuations of macroeconomic aggregates upon the occurrence of aggregate random shocks. Previous contributions on the macroeconomic implications of wage indexation were elaborated by several authors, including Gray [8], Fischer [6], and Cukierman [4]. Gray and Fischer developed frameworks that are closed to exchanges with the rest of the world and concluded that the effects of wage indexation on the magnitude of macroeconomic fluctuations differ according to whether the initial disturbance stems from nominal or real factors. In particular they showed that full indexation of nominal wages to the general level of prices will exacerbate the real effects of real supply shocks while insulating the economy from monetary disturbances. The model specified by Gray and Fischer assumed that employment is demand determined, and, as Cukierman has pointed out, this assumption is arbitrary. Accordingly, Cukierman extended Gray's model and demonstrated that the effects of wage indexation on macroeconomic fluctuations depend on whether it is the demand or the supply of labor which is the dominant component in the determination of employment. More specifically, he established that complete indexation of wages to prices may, contrary to what Gray and Fischer demonstrated, stabilize the effects of real supply shocks, when the supply of labor is the dominant factor in the determination of employment. The existing literature on wage indexation and macroeconomics assumes, a) that shocks across markets are not linked with each other, b) that generally the nominal wage rate is tied only to the price level and c) monetary policy is passive. The analysis in this paper is based on an extension of the models Gray and Cukierman put forth. First, we introduce in the model the concept of a Walrasian budget constraint.' The Walrasian budget constraint specifies that an aggregate shock in the demand for goods may be offset by an increase in the supply of labor,