Endogenous Wage Indexation and Aggregate Supply

Abstract:  Wage indexation---the extent to which wages adjust to unanticipated inflation---is widespread in labor contracts and can play an important role in shaping business cycles. I develop a model in which workers set hourly wages in the presence of productivity and monetary uncertainty, while firms optimally choose labor hours after shocks are realized. Crucially, wages can be made contingent on the realized price level, enabling workers to partially hedge volatility in real earnings and the disutility from work. While indexation allows real wages to absorb adverse supply shocks, it also exposes the economy to monetary disturbances. In equilibrium, I show that the decentralized contract features nominal wages that adjust to inflation with an elasticity less than one and an exact value governed by the workers' relative uncertainty about productivity and money shocks. As the latter dominate, wages become more indexed and the relative pass-through of monetary shocks to output weakens, which manifests as a steepening of the aggregate supply curve. Finally, price stabilization rules are impotent against output volatility, as their impact is fully offset by an increase in the degree of wage indexation.

•  “An Assignment Model Approach to the Labor Share” with Lukas Mann and George Nikolakoudis

• “Wage Indexation and Liquidity Demand” (slides)

• “Currency Pair Triangles in Shapley-Shubik Trading Posts”