Wage Indexation and Monetary Policy

This paper analyzes the effect of indexed wage contracts on inflation and social welfare in a Barro-Gordon model with state-contingent monetary policy. Wage indexation reduces the inflation bias but may raise the variance of inflation rates. In social optimum, wages are fully indexed to the price level, but this requires optimal wage adjustments to productivity shocks. If wage adjustments to productivity are suboptimal, the second-best solution calls for nonindexed wage contracts and a central banker with balanced aspiration levels of employment and real wages. In the case of decentralized wage bargaining, a prohibition of wage indexation may improve welfare.