Endogenous Wage Indexation and Aggregate Supply

Abstract:  The transmission of monetary and real 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 real shocks. When monetary shocks dominate, wage contracts incorporate more indexation, reducing the pass-through of monetary disturbances to output. Moreover, price-stabilizing policy rules fail to stabilize output because wage indexation endogenously adjusts in a way that offsets their effects. Finally, I show that the social planner’s optimal degree of indexation coincides with the decentralized equilibrium outcome.

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