Abstract

Wage indexation (the extent to which wages adjust to unanticipated inflation) is widespread in labor contracts and plays an important role in shaping macroeconomic dynamics. I develop a model in which occupation-specific unions set hourly wages in the presence of aggregate supply and demand uncertainty, while firms optimally choose labor inputs under full information. Wages can be made contingent on realized inflation, enabling workers to partially hedge volatility in earnings and the disutility from labor supply. I show that equilibrium nominal wages adjust less than proportionally to inflation. While this partial indexation allows real wages to absorb adverse supply shocks, it also exposes the economy to monetary disturbances. The equilibrium degree of wage indexation is characterized by a single sufficient statistic: the relative uncertainty between demand and supply shocks. As demand shocks dominate, the pass-through of monetary shocks to output weakens, resulting in a steeper aggregate supply curve.