Wage Indexation and the Time Consistency of Government Policy

Abstract

This paper concerns the role of wage indexation as a mechanism for enabling an economy to achieve outcomes that would not otherwise be time consistent. The desirability of indexation depends on the size of real and nominal shocks and on a policymaker's incentives for short-run inflation surprises. Policymakers' incentives to utilize wage indexation are examined and it is found that 'weak' policymakers are more likely to choose wage indexation. Hence, in an electoral equilibrium, voters may choose a policymaker who cares more about unemployment than inflation but who chooses wage indexation to commit to low inflation. Copyright 1995 by The editors of the Scandinavian Journal of Economics.