While a standard academic presumption has been that wage indexation reduces the cost of disinflation, policymakers generally contend that wage indexing makes disinflation more difficult. To shed light on these views, this paper reexamines the effects of wage indexing on the output loss caused by money-based stabilization. It finds that the cost of disinflation with indexed-wage contracts tends to be smaller than that with contracts that specify preset time-varying wages, but larger than that with contracts that specify fixed wages. Thus, the academic and the policymakers ’ views can both be appropriate depending on the standard of reference.

Abstract

While a standard academic presumption has been that wage indexation reduces the cost of disinflation, policymakers generally contend that wage indexing makes disinflation more difficult. To shed light on these views, this paper reexamines the effects of wage indexing on the output loss caused by money-based stabilization. It finds that the cost of disinflation with indexed-wage contracts tends to be smaller than that with contracts that specify preset time-varying wages, but larger than that with contracts that specify fixed wages. Thus, the academic and the policymakers ’ views can both be appropriate depending on the standard of reference.

IN THE early 1970s, Friedman (1974) proposed the widespread use of indexation clauses in wage contracts and other covenants. He visualized price escalator clauses as a device that would not only reduce the harm done by inflation but also facilitate the end of inflation. In the presence of indexation, he argued, any effects on prices caused by a deceleration in demand would be transmitted promptly to wage and other contracts; this transmission would speed up the impact of stabilization policy on inflation and moderate its adverse repercussions on unemployment.1 By reducing the side effects of disinflation, indexation would also help to make the fight against inflation politically feasible and enhance the credibility of the authorities’ willingness to persist in that fight.

Although Friedman’s recommendation was soon countered on the grounds that wage indexation would make the adjustment of the economy to real shocks more difficult, his view that wage indexation would reduce the cost of disinflation has prevailed in the academic literature. In the standard model, his argument that indexation speeds up the adjustment of wages to changes in inflation is captured by the assumption that indexed wages adjust contemporaneously to the price level, as in the seminal paper by Gray (1976). Under this assumption, indexed wages in any period are tantamount to flexible nominal wages and thereby help directly to stabilize output during disinflation, in comparison to preset nominal wages.2

The academic view notwithstanding, policymakers generally contend that wage indexation makes disinflation more difficult. This fact was first highlighted by Simonsen (1983); it is revealed, for instance, in the papers contained in Williamson (1985). In recent experience, the economic authorities in Chile have pointed to wage indexation to explain why faster disinflation has not been possible in the country, and wage indexing has been prohibited during recent stabilization programs in Argentina and Brazil. Moreover, in several Eastern European countries where wage indexation has been introduced or proposed, the main arguments in favor of this policy highlight its value in mitigating the costs of inflation and attaining social order rather than its ability to make disinflation easier.

A partial reconciliation of these views might be that wage indexation reduces the cost of disinflation while nevertheless making disinflation harder because it palliates the costs of average inflation and thus weakens the will to fight it. The importance of this effect was stressed by Fischer and Summers (1989) in the case of fiscal and financial indexation. The issue was examined in the case of wage indexation by Ball and Cecchetti (1991); using the assumption of contemporaneous indexation within an extended Barro-Gordon (1983) model of inflation, Ball and Cecchetti showed that wage indexing can indeed increase inflation even if it reduces the cost of disinflation. However, this rejoinder is not fully satisfactory because the policymakers’ main allegation on this issue is not that wage indexation weakens the will to fight inflation, but simply that it makes disinflation more costly.3

In order to explain the difference between the views of policymakers and of academics, Simonsen (1983) preferred to conjecture that the lags in actual indexation practices imply that wage indexing in real life raises rather than reduces the cost of disinflation. While the analysis he offered was merely suggestive, his conjecture has seemed to be supported by the results of Bonomo and Garcia (1994).4 These authors replicated Ball’s (1990) analysis of credible disinflation policies in an economy with staggered fixed prices, but they added to the model an indexation rule requiring individual prices to be adjusted by the inflation accumulated since the last adjustment. Like Ball, Bonomo and Garcia found that certain disinflation policies could cause a boom in the economy if they were credible; however, they discovered that under indexation the boom caused by those policies would be followed by a recession, so that the net output gain during the disinflation would be smaller in the indexed economy than in Ball’s economy. They also estimated that the time necessary to reduce inflation without affecting output would be longer in the indexed economy.

However, the notion that lagged wage indexation raises the costs of disinflation is somewhat contradicted by the results obtained earlier by Fischer (1985 and 1988) and Taylor (1983). In his examinations of the effects of a cut in money growth. Fischer found that the cost of disinflation in an economy with ex ante or lagged ex post wage indexation would be smaller than in an economy with predetermined wages. Similarly, in simulations based on the actual structure of union wage contracts, Taylor found that lagged wage indexation as observed in practice increased the speed at which disinflation could be achieved in the United States without an increase in unemployment. However, the indexation rules examined by Fischer do not correspond to the usual formula that links current wage adjustments to past inflation,5 and Taylor’s analysis did not refer strictly to costs of disinflation.

In order to shed light on whether wage indexation raises or reduces the cost of disinflation, this paper reexamines the effects of wage indexing on the output loss caused by money-based disinflation. The analysis reveals that, when the lags observed in actual indexation rules are taken into account, wage indexation can either raise or reduce the cost of disinflation, depending on the standard of reference used. Indexed-wage contracts can be compared with contracts that specify preset time-varying wages, in which the sequence of each contract’s nominal wage can vary according to the information that was available when the agreement was signed, or with contracts that specify a single fixed wage during the term of the agreement. The analysis shows that the cost of disinflation in an economy with indexed-wage contracts tends to be smaller than that in an economy with preset time-varying wage contracts, but larger than that in an economy with fixed-wage contracts.

This result dispels the notion that wage indexation necessarily raises or reduces the cost of disinflation and provides a suitable explanation for the difference between the views of academics and policymakers on the effects of wage indexation on disinflation. The analysts suggests that the academic view is valid if indexed wages are compared with preset time-varying wages, while the policymakers’ view is valid if indexed wages are compared with wages that are fixed during the life of each contract. This explanation accords with the fact that much of the academic literature refers to the United States—where contracts with preset time-varying wages abound in the unionized sector of the labor market and thus seem a relevant yardstick to evaluate the effects of wage indexation—while the policymakers’ view alludes essentially to other countries, where fixed-wage contracts often provide a more appropriate standard of reference.6

According to the analysis, contracts with indexed wages and preset time-varying wages imply similar effects in the initial stages of disinflation. (With both types of contracts, the adjustment of wages to a reduction in expected inflation tends to be postponed until the changes actually occur or are expected to take place.) However, once initial reductions in the inflation rate have been achieved, indexed-wage contracts tend to make disinflation easier because their indexation clauses automatically transmit initial reductions in the inflation rate to wages and inflation in the following periods. After the initial fall in output induced by an unanticipated cut in money growth, and depending on the structure of the economy and the nature of monetary policy, this feedback effect can prevent a larger decline in output, permit a faster recovery, or create a boom following the recession. As a result, the total output cost of the disinflation tends to be smaller with indexed-wage contracts than with preset time-varying wage contracts.

Compared with fixed-wage contracts, indexed-wage contracts tend to raise the cost of disinflation because indexation dampens the responsiveness of wages at the beginning of disinflation. While fixed-wage contracts are front-loaded and thereby maximize current wage adjustment when a persistent reduction in inflation is expected, indexed contracts tend to postpone that adjustment until inflation has fallen, making it less necessary for current wages to adjust. This effect is reinforced at the aggregate level if the indexed contracts are longer in duration than the fixed-wage contracts—which seems to hold in practice—as longer-term contracts reduce the number of wage bargainings held in any period and thus make the current aggregate wage less sensitive to the new macroeconomic conditions. The consequence is that wage indexation magnifies the drop in output that occurs in the initial stages of the disinflation. While the automatic cost of living adjustments in subsequent periods can speed up the recovery and create a boom after the recession is over, the magnitude of this latter effect tends to be smaller. As a result, the total cost of disinflation tends to be larger with indexed-wage contracts than with fixed-wage contracts.

The remainder of this paper is organized as follows. Section I presents a model of indexed-wage contracts and compares the aggregate wage equations implied by these contracts with alternative, nonindexed contracts. Section II studies the effects of wage indexation on the output cost of an unanticipated but credible disinflation, using a simple model of the economy. Section III checks the robustness of the results under alternative assumptions. The last section provides concluding remarks.

I. Wage Indexation and Aggregate Wage Dynamics

This section examines the aggregate wage behavior implied by indexed-and nonindexed-wage contracts. The analysis takes the structure of the contracts as given and assumes uniform staggering. Wage indexation is modeled explicitly as a contract clause that grants periodic adjustments in the contract wage according to a lagged value of the inflation accumulated since the last wage revision.

Indexed-Wage Contracts7

Indexed-wage contracts in real life generally do not provide full protection against fluctuations in the price level. Although they stipulate periodic wage revisions that depend on actual inflation, normally these revisions are not granted in every period and are based on a lagged value of the inflation accumulated since the previous wage adjustment. For instance, in Chile, where most wage contracts are indexed, cost of living adjustments of 100 percent of the inflation accumulated since the last wage revision are typically granted every six months (Jadresic, 1992). In the United States, indexed-wage contracts observed in the unionized sector typically specify an annual cost of living adjustment of a fraction of the inflation measured during the previous year. In both countries, owing to the delays in the availability of consumer price indices, the cost of living adjustments are usually based on a one-month-lagged value of accumulated inflation.8

To study the consequences of wage indexation in a simple framework, assume that cost of living adjustments of 100 percent of the previous period’s rate of inflation are granted in every period.9 If the length of the contracts is denoted by the integer n > 1, uniform staggering implies that in every period 1/n of the wages are negotiated, while the remainder are adjusted according to past inflation. It follows that the variation of the aggregate wage in a given period when contracts are indexed is

wtl=(11n)πt1+1nxt=πt1+1n(xtπt1(1)
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where πt-1 is the past period’s inflation rate and χt is the initial increase in the nominal wage agreed in the recently revised contracts. (Unless explicitly pointed out, variables in this paper are measured in log terms, with lowercase letters representing their first differences, and capital letters their levels.)

Applied discussions of indexed economies often assume that χt− πtt-1 is a negative function of the current unemployment rate or simply a constant. If contracts are revised, however, x, must be agreed upon in the wage negotiations between firms and workers. To determine its value, it is postulated in this paper that the outcome of the negotiations maximizes the expected value of a quadratic function of the average real wage implied by each contract.10

This setup implies that the initial wage increase is determined so as to make the expected average real wage of the corresponding contracts equal to a target real wage that depends on the wage setters’ expectations on the exogenous variables that enter into their objective function. If contracts that begin at time t are negotiated with information on the events that occurred up to time t-1, this relation can be written as

xiissuchthatEt1[Contract’saveragerealwage]=(1ns=0n1Ωt+s),(2)
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where the right-hand side represents the target real wage for the contracts signed for period t to t + n − 1 according to information available in t − 1. To simplify comparisons made below, this target real wage is represented as an average of period-specific target real wages Et-1Ωt+s between s = 0 and s = n − 1. Defining precisely what determines the target real wage is not important in this section; the topic will be addressed in Section III.

To derive the initial wage increase implied by this condition, suppose that wage negotiators agree on a nominal wage Xt for the first period of a contract’s life. Taking into account the indexation rule, it follows that the sequential evolution of the real wage during the contract’s lifetime is

XtPtXt+(PtPt1)Pt+1Xt+(Pt+n2Pt1)Pt+n1,(3)
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where Pt denotes the price level during period t, Pt-1 the price level during period t − 1, and so forth.

Computing first the average of this sequence, and then calculating expectations conditional on information available at time t − 1 and using the resulting expression in equation (2). provides an expression for the initial wage expressed in levels. The initial wage increase can then be obtained as the difference between Xt and the value achieved in period t − 1 by me wage negotiated in period tn:

xt=Xt(Xtn+Pt2Ptn1)=πt1+(1L)Et1[1nt=0n1(Ωt+s+πt+s)].(4)
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where L is the standard lag operator.

Replacing equation (4) in equation (1) implies that aggregate wage behavior with indexed-wage contracts is

wtl=πt1+1n(1L")Et1[1ns=0n1(Ωt+s+πts)].(5)
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The first term on the right-hand side of this equation captures the familiar link between current wage adjustments and past inflation that is associated with wage indexation. In proportion 1/n − 1, this term stems from the indexation clauses contained in the contracts not revised during the reference period. In proportion 1/n, it also corresponds to a benchmark adjustment in the revised wage contracts, with respect to which a “plus” or “minus” initial adjustment is granted. In the aggregate, this term implies that an (unexpected) shock in the previous period’s inflation rate has a proportional impact on current wage adjustments—a direct consequence of the assumption of a one-period-ahead and 100 percent indexation rule.

The second term captures the effect of the initial wage revisions. These revisions can break the mechanical link between aggregate wage changes and past inflation. Whether this link is broken depends on the wage setters’ expectations about the appropriate real wage and the likely inflation during the life of the new contracts, compared with the expectations that they held when the contracts just ended were signed. For example, if the inflation rate expected at t − 1 for the n periods to come is higher than the inflation rate that was expected at tn − 1 for the previous n periods, the aggregate wage will grow faster than past prices.

Note that the second term on the right-hand side of equation (5) implies that the elasticity of the current aggregate wage with respect to a change in expected inflation is equal to 1/n (assuming that current and future inflation rates are all expected to change by the same amount). This elasticity would be zero if the indexation of wages to the price level were contemporaneous: in that case, all wage adjustments would be postponed until the changes in inflation actually occur. This is not the case here, however; owing to the lags in the indexation mechanism, a permanent increase in inflation reduces the real wage proportionally. Thus, unless the target real wage is modified, each contract signed with the new inflation expectations includes an equivalent initial wage increase to compensate for the expected increase in the inflation rate. The impact of these adjustments at the aggregate level is 1/n, as this effect is filtered by the fraction of contracts negotiated in each period.

Alternative Wage Contracts

One possible standard for evaluating the implications of indexed contracts is provided by the case in which the wage in each contract remains fixed during the term of the agreement (as in Taylor, 1980). In this case, if wage settlements attempt to achieve an average target real wage—as in the previous subsection—uniform staggering implies that

wtF=1ns=1nπts+1n(1L)Et1[1ns=0n1(Ωt+s+(ns)πt+s)].(6)
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The first term on the right-hand side of this equation indicates that there is a component of inflationary inertia in the determination of wages even though contracts are not indexed. This inertia comes from a catch-up wage increase granted in the revised contracts, which compensates for the depreciation—owing to inflation—of the real value of the wages agreed in the negotiations held n periods earlier. As only a fraction of the contracts are renegotiated in every period, the impact of these catch-up adjustments at the aggregate level is equivalent to 1/n times the inflation accumulated in the last n periods. This implies that the impact of last period’s inflation rate on current wages is 1/n. significantly smaller than the unit elasticity found for indexed contracts (for n > 1).

The second term on the right-hand side corresponds to the wage increase above or below the catch-up term granted in the revised contracts. its interpretation is similar to the case of indexed contracts, except that the impact of a change in expected inflation on the current aggregate wage is larger. Computing the sum of the weights attached to the current and future inflation variable in equation (6) implies that the expectation of a permanent increase in inflation raises the current aggregate wage by a proportion of (n + 1)/2n. As this expression is always larger than 1/n for n > 1, it is larger than the elasticity of indexed wages with respect to expected inflation. The intuition is that, as fixed-wage contracts are front-loaded and do not offer any cost of living adjustments, these contracts tend to be much more sensitive to changes in inflation expectations when they are renegotiated.

Another alternative is to have contracts that specify preset time-varying wages, in which the sequence of each contract’s nominal wage can vary according to the expectations that were held when the agreement was signed (as in Fischer, 1977, 1985, and 1988). In this case, wage. setters can go beyond the attempt to achieve an average expected real wage and target a specific real wage for each period instead. With uniform staggering, it can be shown that such behavior leads to

wtP=1ns=1nEts(πtωt)+1n(1Etn1)s=1n(πts+ωts),(7)
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where Et-sωt is the expected change in the target real wage between t − 1 and t according to information at ts, and so forth.

The first term on the right-hand side of equation (7) contains the adjustment of wages stemming from the changes in expected prices and the targeted real wage, according to the information that was available at the time that the contracts were signed. The second term captures the effect of the updating of wages in the recently negotiated contracts, which depends on the discrepancy between the inflation and target real wage forecasts in the previous negotiation and their actual values.

Note that equation (7) shows a different form of inflationary inertia: if the target real wage is constant, the current aggregate wage is determined by past expectations about current inflation and observed forecasting errors. The consequence is that the elasticity of the current aggregate wage with respect to a shock in the previous-period inflation rate is the same as in the fixed-wage contracts case: 1/n. However, the elasticity of the current aggregate wage with respect to a shock in expected inflation is the same as in the indexed-wage contracts case: 1/n. The intuition for the latter result is that, when both type of contracts are negotiated, the adjustment of wages tends to be postponed, either until the changes in inflation actually occur (in the case of indexed-wage contracts) or until they are expected to occur (in the case of contracts with preset time-varying wages).

Table 1 summarizes the elasticities of the current aggregate wage in response to a shock in the previous-period inflation rate and to a change in expected inflation for indexed-wage contracts, preset time-varying wage contracts, and fixed-wage contracts.11

Table 1.

Elasticity of the Current Aggregate Wage

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II. Wage Indexation and the Cost of Disinflation: Basic Results

In order to gauge the effects of wage indexation on the cost of disinflation, Sections II and III examine the behavior of inflation and output during money-based stabilization, using the different wage equations previously derived. In this section, the analysis is carried out using a simple model for the remainder of the economy under the assumption that the reduction in money growth is unexpected but permanent and credible.

A Simple Model of the Remainder of the Economy

In the base model to be studied, output (Yt) is driven by real money balances

Yt=mtπt,(8)
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where the variable mt represents the rate of growth of money, assumed to be the monetary authority’s policy instrument. It is also possible to interpret this variable as the rate of change in nominal aggregate demand, and to suppose that the monetary authority regulates it through changes in the interest rate.

As in Fischer (1985), Ball (1990), Taylor (1980), and others, inflation is assumed to be given by the rate of change of wages:

πt=wt.(9)
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Finally, the target real wage for a given period is supposed to be determined by the expected level of average output for the same period:

EtsΩt=EtsYt.(10)
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Costs of Disinflation

Consider a set of economies characterized by equations (8), (9), and (10) but differing in that their wages are set according to indexed contracts, preset time-varying wage contracts, and fixed-wage contracts. Either the fixed-wage contracts could be of the same duration as the indexed-and preset time-varying wage contracts, in which case they will be identified below as long-term fixed-wage contracts, or they could be half as long, in which case they will be identified as short-term fixed-wage contracts. This is a useful distinction to make because, in practice, contracts with fixed wages are likely to be shorter in duration than contracts with indexed or preset time-varying wages, as argued below.

Suppose that long-term stability in money growth, inflation, and output in these economies is upset by a permanent reduction in the rate of money growth, which, although unanticipated, is credible since its announcement and implementation in period t = 1. What is the path for inflation and output in each economy? What is the total cost of the disinflation in each ease?

Figure 1 shows the behavior of inflation and output implied by such a shock in the four economies under consideration.12 The paths for these variables were obtained by solving equations (8), (9) and (10), together with either equations (5), (6), (6) with n replaced by n/2, or (7), depending on the type of wage contract. Since it proved difficult to find analytical solutions for inflation and output as a function of the length of the contracts in all the relevant experiments, it was necessary to choose a specific contract length to solve the implied dynamic equations numerically. For practical purposes, n was set equal to four. In simulations using other values for this parameter, the results did not change in their essentials; in particular, the ranking of costs of disinflation, measured as the net output sacrifice during the stabilization, did not change.

Figure 1.
Figure 1.

Money Growth Stabilization with Base Model

(Log deviation from final steady state)

Citation: IMF Staff Papers 1996, 004; 10.5089/9781451930931.024.A006

It is not surprising that, as observed in Figure 1, the reduction in money growth leads to a recession in all four economies: when the new monetary policy is announced and implemented, the short-run dynamics of wages in all cases is mostly determined by past events and decisions consistent with higher money growth. The interesting exercise is to compare the behavior of output throughout the different economies.

Compare first disinflation in the indexed economy with disinflation in the economy with preset time-varying wages. In the initial stages of the disinflation, the path of output in both economies is quite similar. This is because in the short run the evolution of wages depends crucially on the elasticity of the aggregate wage with respect to the expected disinflation, which is the same in both economies (1/n). As time goes by. however, the automatic adjustment of wages to past inflation implied by indexation increasingly changes the behavior of output in the two economies. In the policy experiment considered in Figure 1, the main difference is that the indexed economy experiences a boom following the recovery. To understand the origin of this boom, note first that, during a recovery, the economies under consideration must undergo a period in which inflation is below the new rate of money growth. In the indexed economy, once the economy reaches full employment, the indexation clauses continue converting the low previous inflation into low current inflation; because the new rate of money growth is constant, the consequence is a boom. In the economy with predetermined wages, this boom does not develop because of the absence of automatic cost of living adjustments. The net output loss during the adjustment to the new steady state is thus smaller in the indexed economy than in the economy with preset time-varying wages (Table 2, first row).13

Table 2.

Net Output Loss During Money Growth Stabilization a

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Sum of log deviations of output from its steady state level in response to a cut in money growth of. 01 in log terms.

Disinflation policies with more complex paths for the rate of growth of money can eliminate the boom experienced by the indexed economy following recovery. However, the absence of a boom under an alternative disinflation policy does not mean that the output sacrifice would be larger in the indexed economy than in the economy with preset time-varying wages. For instance, it can be shown by numerical simulation that, with a monetary policy designed lo obtain a linear disinflation in the indexed economy, that economy displays no boom following the recovery but enjoys a faster disinflation and thus a faster recovery to full employment than the economy with preset time-varying wages. As a result, the cost of disinflation still turns out to be smaller in the indexed economy.14

Compare now the behavior of the indexed economy with the behavior of the economies with fixed-wage contracts. During the initial stages of the disinflation, the indexed economy suffers a larger drop in output because the response of its aggregate wage to the expected disinflation is smaller, and its inflation rate falls comparatively little when the new monetary policy is announced. Afterward, both the indexed and the fixed-wage economies recover; as already noted, the indexed economy experiences a boom after the recession. This boom, however, does not compensate for the deeper recession experienced by the indexed economy in the initial stages of disinflation, so that the net output sacrifice is greater than in either of the economies with fixed-wage contracts. Not surprisingly, the differences are maximized when the standard of reference is the economy with short-term fixed-wage contracts. As shorter contracts are negotiated more often, they make the aggregate wage more sensitive to the stabilization policy during the initial stages of disinflation (Table 2, first row).

III. Robustness

This section examines how the basic results are modified if the disinflation is partially credible or anticipated, or if some of the structural assumptions about the economy are relaxed.

Partial Credibility

In reality, even successful stabilization programs are not fully credible when they are implemented; they gain credibility as time goes by. What are the consequences of partial credibility for disinflation in the different economies? Does it modify the ranking of costs of disinflation for the various wage contracts obtained in the previous section?

Figure 2 considers the case in which wage setters believe that, starting in the period after the disinflation has been announced and implemented, the money growth will revert permanently to its prestabilization level with probability qt; conversely, the wage setters believe that money growth will remain always unchanged at the stabilized level with probability 1 − qt. For the sake of concreteness, the figure focuses on the case in which the perceived likelihood of a policy reversal declines exponentially according to the formula qt = (½)t.

Figure 2.
Figure 2.

Money Growth Stabilization with Partial Credibility

(Log deviation from final steady slate)

Citation: IMF Staff Papers 1996, 004; 10.5089/9781451930931.024.A006

In all the economies, not surprisingly, the recession induced by the disinflation turns out to be deeper and longer than in the base model of full credibility: the fall in output is larger and the recovery of output to full employment levels takes more time. The important result, however, is that partial credibility does not alter the ranking of costs of disinflation (Table 2, second row).

Anticipated Disinflation

What is the effect on the different economies of an anticipated cut in money growth? This is an interesting case to look at from a theoretical point of view. Ball (1990) found that, in an economy with fixed-wage contracts, a credible and gradual reduction in money growth can generate a boom rather than a recession. This can happen if the reduction in money growth during the initial stages of disinflation is smaller than the reduction in wage increases owing to the expected disinflation.

To consider the most extreme case. Figure 3 examines the effects of a fully anticipated cut in money growth on the base model. As the expected disinflation reduces wage increases in anticipation of the actual cut in money growth, the economies with fixed-wage contracts now experience a boom, as in Ball’s model. The indexed economy also experiences a boom, but this boom is followed by a recession (for reasons analogous to the ones that explain the boom after the recovery in the base mode!). Finally, output in the economy with preset time-varying wages is not affected by the disinflation, as all the necessary wage adjustments are included in the contracts sufficiently in advance.

Figure 3.
Figure 3.

Money Growth Stabilization, Fully Anticipated

(Log deviation from final steady state)

Citation: IMF Staff Papers 1996, 004; 10.5089/9781451930931.024.A006

How do the output effects of the disinflation compare across the different economies’? Compare first the indexed economy with the economy with preset time-varying wages. Although the paths of output in both economies are quite different, the net output loss is zero in both cases (Table 2, third row). In this sense, it can be said that the “cost” of a fully anticipated disinflation in these economies is similar. This finding only slightly qualifies the result obtained previously that indexed wages make disinflation easier than preset time-varying wages, as a fully anticipated disinflation is an unlikely event in practice. Compared with the economies with fixed-wage contracts, the economy with indexed contracts dampens the magnitude of the boom caused by the anticipated disinflation and. in addition, creates a recession. Under the standard interpretation that output gains are welfare improving, this result implies that disinflation is harder with indexed-wage contracts than with fixed-wage contracts, as in the previous experiments (Table 2, third row).

Procyclical Ratio Between Prices and Wages

The assumption that price inflation equals wage inflation presumes that the changes in output occurring during the disinflation do not have a direct impact on prices. An alternative assumption is that, given wages, prices are procyclical. For instance, increases in the level of output could raise the firms’ marginal costs or the price elasticities of the individual demands that the firms face.

If the price-wage ratio is procyclical. the fall in output associated with an unanticipated cut in money growth moderates price increases independent of the impact of the money cut on wages. As shown in Figure 4. this effect reduces the cost of disinflation in all the economies under study (the figure assumes that a 1 percent fall in output reduces the price-wage ratio by 0.5 percent). The relative impact on the costs of disinflation, however, is different across the various economies. In the economy with indexed contracts, the initial reduction in the inflation rate automatically feeds back into smaller wage adjustments in following periods, so that the costs of disinflation—compared with the base model—diminish more than in the other economies (Table 2, fourth row).

Figure 4.
Figure 4.

Money Growth Stabilization with Procyclical Price-Wage Ratio

(Log deviation from final steady state)

Citation: IMF Staff Papers 1996, 004; 10.5089/9781451930931.024.A006

Under this assumption, therefore, the base model result that the cost of disinflation in the indexed economy is smaller than in the economy with preset time-varying wages is strengthened. However, the base model result that the cost of disinflation in the indexed economy is larger than in the economies with fixed-wage contracts is weakened under this assumption. Indeed, for the assumed elasticity of the price-wage ratio, the cost of disinflation in the indexed economy is similar to—and actually somewhat smaller than—that in the economy with fixed-wage contracts of the same duration.

Nevertheless, the possibility that a procyclical price-wage ratio can make disinflation easier with indexed- than with fixed-wage contracts is more theoretical than practical. First, there is no reason to presume in practice a significant positive effect of output on prices, given wages. As summarized by Blanchard and Fischer (1989, pp. 464–7), most empirical studies are consistent with the notion that marginal costs are roughly constant or perhaps even declining, and, moreover, there are several theoretical reasons why imperfectly competitive firms may choose countercyclical markups. Second, as a main microeconomic function of wage indexation is to prevent the frequent negotiations associated with fixed-wage contracts, the relevant comparison is in practice between indexed contracts and short-term, rather than long-term, fixed-wage contracts. Indeed, while indexed contracts normally last two years in Chile and three years or longer in the U.S. unionized sector, typical fixed-wage contracts around the world seem to last for only one year.

Sensitivity of the Target Real Wage

The base model assumption that the target real wage is proportional to the expected level of output is consistent with the empirical evidence on the relationships between wages and unemployment, and between unemployment and output. Blanchflower and Oswald (1995) have summarized their extensive research on the “wage curve” by stating that a 1 percent increase in the unemployment rate typically reduces the real wage by 0.1 percent, and the typical estimates for the Okun’s Law coefficient range between 2 and 3 (for example, see Adams and Coe, 1990). With an unemployment rate near 5 percent, these estimates imply that a 1 percent increase in GDP would raise the real wage on the order of 1 percent, as assumed in the base model.

Nevertheless, there is still the question of what would happen if the value of the elasticity of the target real wage with respect to the level of output were other than 1. To consider one specific case, Figure 5 depicts the behavior of output and inflation in the base model, but under a smaller elasticity, equal to 0.5. Not surprisingly, the recession in the four economies deepens. In addition, the economies with indexed- and fixed-wage contracts now take more time to return to their states of full employment. The ranking of costs of disinflation, however, is not modified (Table 2, fifth row).

Figure 5.
Figure 5.

Money Growth Stabilization with Less Sensitive Target Real Wages

(Log deviation from the final steady state)

Citation: IMF Staff Papers 1996, 004; 10.5089/9781451930931.024.A006

Interest-Elastic Money Demand

The base model implicitly assumes a cash-in-advance constraint, under which interest rates play no role. In practice, however, money demand is interest elastic, so that a cut in money growth is likely to modify the velocity of money and thus break the strict link between money and output, given prices. What is the resulting impact on the costs of disinflation in the different economies?

To provide an answer, Figure 6 examines the effects of interest-elastic money demand. The behavior of output and inflation in this case was obtained by replacing aggregate demand equation (8) with a standard IS-LM specification:

Yt=MtPt+αit,(11)
A06lev3sec13
Yt=β(itEtπt+1),(12)
A06lev3sec13

where it is the nominal interest rate in period t. and α and β are positive parameters. The simulations on which the figure is based assume α = β = 0.5.

Figure 6 shows that the recession caused by the disinflation policy under this specification for aggregate demand is less severe than in the base model for the four economies under consideration. Indeed, as inflation is expected to fall slowly during the initial stages of the disinflation—owing to the inertia stemming from the contracts—the initial drop in output is attained by way of a rise in the nominal interest rate; the concurrent increase in the velocity of money attenuates the fall in output, moderating the severity of the recession. Because this effect shows up in all four economies, the ranking of the costs of disinflation previously obtained is not modified (Table 2. sixth row).15

Figure 6.
Figure 6.

Money Growth Stabilization with Interest-Elastic Money Demand

(Log deviation from final steady state)

Citation: IMF Staff Papers 1996, 004; 10.5089/9781451930931.024.A006

Open Economy

Following the related literature, the analysis thus far has focused on the effects of indexation on the costs of disinflation in a closed economy setting. This is a relevant framework for studying the effects of wage indexation on the costs of disinflation: in practice, countries with significant wage indexing have often also been countries with closed capital accounts or poor access to the International capital markets. The results obtained to this point are directly applicable to an open economy with limited capital mobility if the policymaker adjusts the nominal exchange rate to keep the real exchange rate constant.16

In an economy integrated with the International capital markets, however, an unanticipated money-based stabilization is likely to strengthen the domestic currency at the time of its announcement. This strengthened currency could rapidly reduce or curb the price of tradable goods and inputs, helping to break the inflationary inertia at the beginning of the disinflation. A priori, it seems likely that this mechanism would reduce the costs of the disinflation in general, but especially so in the indexed economy, as the cost of living adjustment clauses in the indexed contracts would automatically feed back the low inflation rate observed at the beginning of the disinflation into reduced wage increases in the following periods.

The simplest way to examine the effects of indexation on disinflation in an open economy is to modify the base model to distinguish between a domestic and a foreign good in a Mundell-Fleming setting. For this purpose, redefine Yt as domestic output and replace aggregate demand and price equations (8) and (9) by the relationships

Yt=βEt[st+1πt+1]+γ(StWt),(13)
A06lev3sec14
Yt=mtπt,and(14)
A06lev3sec14
πt=δwt+(1δ)st,(15)
A06lev3sec14

where St is the nominal exchange rate in period t, defined as the price of foreign currency in terms of domestic currency. The parameters β, γ, and δ that appear in these equations are positive, with β smaller than 1.

Equation (13) is an IS curve, linking the level of domestic output to the expected real interest rate under the assumption of perfect capital mobility. The equation also links the level of domestic output to the real exchange rate, defined as the ratio of the nominal exchange rate to domestic wages (the International interest rate and the price of the foreign good are omitted for convenience). Equation (14), in turn, is an LM curve derived from a money demand function and specified with zero interest elasticity, so as to separate the effect of opening the economy from the effect of considering an interest-elastic money demand, examined above. Finally, equation (15) provides the definition of the aggregate price level, expressed in rate of change form.

Figure 7 shows the behavior of inflation and output using these modifications to the model (for β = 0.5. γ = 0.3. and δ = 0.7). Owing to the jump in the exchange rate at the time of the reduction in money growth, inflation now abates rapidly in all four economies. Because wages continue growing fast for some time, however, output still falls significantly during the initial stages of the disinflation. Thereafter, owing to the automatic feedback of the rapid initial disinflation into the subsequent cost of living adjustments, the recovery in the economy with indexed wages is faster than in the economies with preset time-varying wages and long-term fixed wages. The faster recovery implies that the output cost of the disinflation in the indexed economy is not only smaller than in the economy with preset time-varying wages but also somewhat smaller than in the economy with long-term fixed-wage contracts. Nonetheless, the indexed economy still displays a higher disinflation cost than the economy with short-term fixed-wage contracts (Table 2, seventh row).

Figure 7.
Figure 7.

Money Growth Stabilization with Open Economy

(Log deviation from final steady slate)

Citation: IMF Staff Papers 1996, 004; 10.5089/9781451930931.024.A006

IV. Concluding Remarks

This paper has shown that the effects of wage indexing on the output loss caused by money-based stabilization depend on the yardstick used. On the one hand, the indexed economy tends to display smaller disinflation costs than an economy with contracts that specify preset time-varying wages. This is because, once initial reductions in the inflation rate have been achieved, indexation automatically feeds those reductions back into wages and inflation in following periods. This effect can prevent a larger deterioration of output, permit a faster recovery, or create a boom following the recession caused by disinflation. On the other hand, the indexed economy tends to exhibit larger disinflation costs than an economy with fixed-wage contracts. While wage indexation still has an advantage because it automatically feeds back previous reductions in the inflation rate, it also has a larger disadvantage because it reduces the responsiveness of wages during the early stages of a disinflation. This reduced responsiveness makes it harder to break any initial inflationary inertia in the indexed economy, thereby deepening the recession caused by a sudden reduction of money growth.

The simulations performed in this paper indicate that these results are robust under a set of alternative circumstances. The main qualification emerging from the robustness analysis relates to the finding that indexed contracts make disinflation harder than fixed-wage contracts. That result can be reversed for contracts of the same duration if early in the disinflation there is a sizable fall in prices independent of wages—owing, for instance, to a significant appreciation of the domestic currency or to a sharp drop in marginal costs. Nonetheless, this qualification seems more theoretical than practical, as relevant fixed-wage contracts appear to be shorter than indexed-wage contracts. In the simulations, when indexed contracts were compared with fixed-wage contracts of half their duration, the basic result emerged unchanged.

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*

Esteban Jadresic is an Economist in the Research Department. He holds a Ph.D. from Harvard University. The author is grateful to Alex Hoffmaister, Patrick Honolulu, Assaf Razin, Miguel Savastano, Peter Wickham, and seminar participants at the Fourteenth Latin American Meeting of the Econometric Society (Rio de Janeiro, August 1996), and at the International Monetary Fund for helpful comments.

1

Friedman (1974, p. 43) wrote:

Most important, indexation will shorten the time it takes for a reduction in the rate of growth of total spending to have its lull effect in reducing the rate of inflation. As the deceleration of demand pinches at various points in the economy, any effects on prices will be transmitted promptly to wage contracts, contracts for future delivery, and interest rates on outstanding long-term loans. Accordingly, producers’ wage costs and other costs will go up less rapidly than they would without indexation …. With widespread indexation, in sum, firm monetary restraint by the Federal Reserve System (the “Fed”) would be reflected in a much more even reduction in the pace of inflation and a much smaller transitory rise in unemployment.

2

The view that wage indexation reduces the cost of disinflation can be found, for instance, in Taylor (1983), Fischer (1985 and 1988), Devereux (1989), Fischer and Summers (1989), Ball and Cecchetti (1991), VanHoose and Waller (1991), Waller and VanHoose (1992), Milesi-Ferretti (1994), and Crosby (1995). Two well-known references on wage indexation excluded from this list are Gray (1976) and Fischer (1997); although they argued that wage indexation helps to stabilize output when nominal shocks occur, they referred strictly to shocks in the level of money demand or supply rather than to shocks in the rate of growth of those variables. Surveys on the literature on wage indexation can be found in Aizenman (1987), Carmichael, Fahrer, and Hawkins (1985), Devereux (1994), and Van Gompel (1994).

3

For example, the Central Bank of Chile (1994, pp. 19–20) explained recently:

The slow adjustment of nominal wages shows the relevance of inertial aspects in Chilean inflation. The institutions and usual practices in our economy are marked by the memory of high-inflation episodes, which has led to widespread indexation as a form of insurance against inflationary surprises. The inflationary inertia associated with this widespread indexation puts a limit on the speed of the disinflation, so as to avoid the important costs in economic activity that would arise in the case of a rapid disinflation. (translation by the author).

Also, see Williamson (1985).

4

Simonsen explored the issue by adding a lagged inflation term to an expectations-augmented Phillips curve. Several authors have followed his approach to modeling the consequences of wage indexation; recent examples arc De Gregorio (1995) and Milesi-Ferretti (1995).

5

Under Fischer’s ex ante indexation rule, indexed nominal wages are set according to the expectation held ut t-1 about the price level at t: the implied cost of living adjustment is the difference between the one-period-uhead expectations on the current and past price levels. Under his lagged ex post indexation rule, indexed nominal wages are set equal to the price level observed at t-1 when there is a cost of living adjustment, and they are equal to the expectation held at t-1 about the price level at t when there is a contract revision. As in this ease, Fischer focused on two-period contracts; the implied cost of living adjustment (granted at the contract midlife) is the difference between the actual price in the previous period and the one-period-ahead expectation about the same price.

6

Indeed, Friedman (1974), Taylor (1983), and Fischer (1985 and 1988) referred mostly or solely to the U.S. economy and used preset time-varying wages as their standard of reference. Bonomo and Garcia (1994), in turn, referred explicitly to high-inflation economies and used fixed prices as the standard of reference. However, Bonomo and Garcia argued that disinflation with indexation is also more difficult than with preset time-varying prices.

7

This section is based on Jadresic (1991).

8

Contracts with trigger-point indexation can offer better protection against price fluctuations but arc less common in practice. The implications of this alternative type of contract are not studied here.

9

The cases in which the cost of living adjustments are not granted in every period and in which the degree of indexation is less than 100 percent were analyzed in Jadresic (1992).

10

The goal of maximizing a nonlinear function of the real wage is implied by different microeconomic models of wage determination, including the union wage model and the efficiency-wage model. The specification of the maximand as a quadratic function of the real wage is used to introduce expected variables in a log-linear manner and can be interpreted as a second-order approximation of the actual objective function. The assumption that the average real wage rather than its present value matters simplifies the algebra.

11

In terms of a distinction used by Chadha, Masson, and Meredith 1992), these elasticities provide analytical measures of the backward-looking and forward-looking components of current wage adjustments associated with each type of contract. Note, however, that while these authors assumed that the elasticities corresponding to these two components add up to 1, the sum in this paper is always different from unity for viable contract lengths.

12

The reduction in money growth has been normalized to 0.01 in log terms.

13

The boom in the indexed economy is followed by a sequence of recession-and-boom cycles of decreasing amplitude. These cycles are generated by factors analogous to those generating the first boom, and they fade away relatively fast. Their (marginal) effect is taken into account in Table 2.

14

It is found below that, in comparison to preset time-varying wages, indexed wages may also prevent a larger deterioration of output after the initial impact of the cut in money growth. This effect can also help to make disinflation easier in the indexed economy.

15

An alternative approach to studying the effects of an interest-elastic money demand is to replace aggregate demand equation (8) by equation (11) and a modified IS equation linking the expected real interest rates to the expected change in output, as suggested by the standard consumer’s Euler equation. Simulations performed under this alternative specification, using a range of intertemporal rates of substitution, produce the curious result of a decline in the nominal interest rate at the beginning of the disinflation. (Under this specification, the real interest rate has to be relatively low at the time of the shock, so that output can be expected to continue falling for some time, in accordance with the temporary persistence of inflation after the cut in money growth.) The concurrent reduction in the velocity of money aggravates the initial drop in output and the severity of the recession caused by the cut in money growth in all four economies under consideration. The ranking for the costs of disinflation remains unchanged.

16

More generally, the results are also applicable to an open economy in which fiscal policy or capital controls are adjusted to keep the real exchange rate constant.

IMF Staff papers: Volume 43 No. 4
Author: International Monetary Fund. Research Dept.
  • View in gallery

    Money Growth Stabilization with Base Model

    (Log deviation from final steady state)

  • View in gallery

    Money Growth Stabilization with Partial Credibility

    (Log deviation from final steady slate)

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    Money Growth Stabilization, Fully Anticipated

    (Log deviation from final steady state)

  • View in gallery

    Money Growth Stabilization with Procyclical Price-Wage Ratio

    (Log deviation from final steady state)

  • View in gallery

    Money Growth Stabilization with Less Sensitive Target Real Wages

    (Log deviation from the final steady state)

  • View in gallery

    Money Growth Stabilization with Interest-Elastic Money Demand

    (Log deviation from final steady state)

  • View in gallery

    Money Growth Stabilization with Open Economy

    (Log deviation from final steady slate)