Endogenous Wage Indexation and Monetary Policy

Abstract: The transmission of monetary and cost shocks to the aggregate economy hinges on the degree of wage rigidity. I develop a model of endogenous wage indexation in which workers choose how strongly wages should adjust to inflation surprises. In equilibrium, wages catch up with unanticipated inflation only partially, and the degree of indexation is determined by the relative uncertainty surrounding monetary versus cost shocks. When monetary shocks dominate, wage contracts incorporate more indexation, reducing the pass-through of monetary disturbances to output. Finally, the endogenous nature of indexation offsets the output-stabilizing effects of an inflation-targeting monetary rule.