On the absence of positive wage indexation

This paper rationalizes the absence of positive wage indexation in labour contracts - that is, of indexing provisions that link wage increases to inflation. We investigate the equilibrium of a policy game in a stochastic economy in which wage-setters and a policy-maker interact strategically in order to determine the preferred degree of wage indexation and an optimal stabilization rule, respectively. Our conclusion is that nominal wage rigidity and counter-inflationary economic policy represent the best courses of action when price stability is valued and negative responses of contractual wages to price shocks are ruled out. Under these assumptions, moreover, the stochastic structure of the economy has no bearing on the optimality of maximal real wage flexibility.