Endogenous Wage Indexation and Aggregate Shocks

By: Julio Carrillo, Gert Peersman and Joris Wauters


Wage indexation practices have changed. Evidence on the U.S. for instance suggests that wages were heavily indexed to past inflation during the Great Inflation but not during the Great Moderation. However, most DSGE models assume fixed indexation parameters in wage setting, which might not be structural in the sense of Lucas (1976). This paper presents a New-Keynesian model in which workers, by maximizing their welfare, set their wage indexation rule in response to aggregate shocks and monetary policy. We find that workers index their wages to past inflation when technology and permanent inflation-target shocks drive output fluctuations; when aggregate demand shocks do, workers index to trend-inflation. In addition, workers’ choices do not coincide with the social planner’s choice, which may explain the observed changes in wage indexation in the post-WWII U.S. data.

Many are unhappy about the way macro models deal with price and wage rigidities, and properly understanding indexation is a neglected part of this reflection. This paper provides an interesting tack at this question. Critical here is the choice set of indexation rules. The relevant part of the paper is here:

[..] in periods in which wages are re-optimised, workers select an indexation rule among two different types: one based on past inflation, and the other one based on the inflation target of the Central Bank (i.e. trend inflation, which may vary). Workers then choose the rule associated with the highest expected utility, given the average length of the labor contract and the regime’s economic characteristics. Similar to Schmitt-Grohe and Uribe (2007), we solve the non-linear model to compute the welfare criterion of workers. The sum of all workers’ decisions determines the degree at which nominal wages are indexed to past inflation on average. We name this level the degree of aggregate indexation in the economy. We implement an algorithm that computes the equilibrium level for aggregate indexation, given the economic regime.


One Response to Endogenous Wage Indexation and Aggregate Shocks

  1. For those interested, you can find the latest version of the paper, plus technical appendix, on my website


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