Academic journal article Atlantic Economic Journal

Asymmetric Wage Indexation

Academic journal article Atlantic Economic Journal

Asymmetric Wage Indexation

Article excerpt

James P. Cover (*)

David D. Van Hoose (**)

Introduction

The years since the seminal work by Gray [1976] and Fischer [1977] have witnessed the development of a voluminous literature concerning the macroeconomic implications of nominal wage indexation. This literature indicates that, in general, the extent to which wages are indexed to unanticipated inflation rises as aggregate demand variability increases relative to aggregate supply variability. And yet, as Fischer [1986, pp. 152-153] and Gordon [1990, pp. 1139-1140] have noted, there has been a surprisingly incomplete degree of voluntary pricelevel indexation in most nations even during periods of significant demand-side volatility. Gordon has called this apparent failure of wage setters to index their contracts optimally the indexation puzzle.

The literature offers several possible solutions to the indexation puzzle. Fischer [1986, p. 153] suggests that short-run inflation uncertainty in low-inflation nations may be so low that welfare differences with and without indexation may be of second-order magnitudes, or that contract negotiation costs may reduce the extent to which such clauses appear. Ball [1988] shows how differential negotiation costs at heterogeneous firms can indeed lead to individually optimal indexation choices that are lower than those that would otherwise have been socially optimal. In contrast, Duca and VanHoose [1991] provide a multisector theory in which individual wage setters index both to a consumer price index and to sectorial firm profits, so that the extent of CPI indexation could be lower as a result of a trade-off between indexing with respect to the different variables. In particular, Duca and VanHoose [1998a, b] provide evidence that greater competition in U.S. goods markets has contributed to a shift away from CPI in dexation in favor of increased profit-sharing arrangements.

Furthermore, Waller and VanHoose [1992] demonstrate that individually optimal indexation may be too low if discretionary monetary policy produces an aggregate inflationary bias that atomistic wage setters fail to internalize when they negotiate indexed nominal wage contracts. In addition, VanHoose and Waller [1991] and Milesi-Ferretti [1994] show that a lack of indexation is a natural outcome in an environment in which a discretionary monetary authority determines its policies after observing disturbances; the authority's optimal policy in such a setting is to offset demand-side shocks completely, thereby eliminating the incentive to index wages. Finally, Bryson et al. [1998] conclude that strategic complementarities arise when wages are indexed in interdependent economies, so that the extent of indexation in such economies arguably may be lower than the social optimum.

This paper offers an even more basic solution to the indexation puzzle. It is based on the observation that wage contracts typically are indexed only to unanticipated increases in the price level, whereas the above literature unrealistically assumes that nominal wages are indexed symmetrically in both upward and downward directions. (1) It also shows that once the asymmetric nature of indexing is considered, the general lack of indexation during periods of significant demand-side volatility is not surprising, nor is the more widespread use of indexation during intervals when supply-side shocks dominate. This conclusion follows because of the nature of an optimal wage contract with asymmetric indexation. Under such a contract, workers are insured that their real wages will rise when prices decline unexpectedly and that their real wages will not fall proportionately in the event of an unanticipated rise in prices. But workers must pay a premium for this real wage insurance. An optimal asymmetrically indexed con tract requires that workers accept a base wage that is lower than the base wage that would arise in a symmetrically indexed contract. This implies that workers face a trade-off between the base wage and the degree of indexation when setting the terms of an asymmetrically indexed contract. …

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