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Supply Shocks, Wage Indexation and Monetary Accommodation

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  • Aizenman, Joshua
  • Frenkel, Jacob A

Abstract

This paper develops a unified framework for the analysis of wage indexation and monetary policy in the presence of supply shocks. We first present simple formulae for the optimal wage indexation rule and for the optimal money supply rule. In order to set the stage for an evaluation of departures from the optimal policy rules we first analyse two extreme cases -- a rule that stabilizes employment and a rule that stabilizes the real wage. The analysis of these two extreme cases provides the ingredients for the evaluation of various rules for wage indexation and for monetary targeting. We examine the implications of indexing wages to (i) nominal GNP, (ii) the CPI and (iii) the value-added price index, as well as the implications of targeting the money supply to these alternative three indicators. It is shown that, the various indexation rules bear a dual relation to the various monetary targeting rules. The welfare ranking of the various rules depends on whether the elasticity of the demand for labor exceeds or falls short of the elasticity of labor supply. If the demand for labor is more elastic than the supply, then policy rules that stabilize employment produce a smaller welfare cost than policy rules that stabilize the real wage. In that case, indexing wages to nominal GNP results in a smaller welfare cost than indexing to value-added price index which, in turn, produces a smaller cost than indexation to the CPI. Because of the dual relation between monetary policy and wage indexation, it follows that under the same circumstances, monetary policy that targets nominal GNP produces a smaller welfare cost than policy that targets the value-added price index which, in turn, results in a smaller cost than the policy that targets the CPI. This ranking is reversed when the elasticity of the supply of labor exceeds the elasticity of demand.
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  • Aizenman, Joshua & Frenkel, Jacob A, 1986. "Supply Shocks, Wage Indexation and Monetary Accommodation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 18(3), pages 304-322, August.
    • Handle: RePEc:mcb:jmoncb:v:18:y:1986:i:3:p:304-22
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    1. Blinder, Alan S. & Mankiw, N. Gregory, 1984. "Aggregation and stabilization policy in a multi-contract economy," Journal of Monetary Economics, Elsevier, vol. 13(1), pages 67-86, January.
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    Cited by:

    1. Turnovsky, Stephen J, 1987. "Supply Shocks and Optimal Monetary Policy," Oxford Economic Papers, Oxford University Press, vol. 39(1), pages 20-37, March.
    2. Benjamin M. Friedman & Kenneth N. Kuttner, 1996. "A Price Target for U.S. Monetary Policy? Lessons from the Experience with Money Growth Targets," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(1), pages 77-146.
    3. Peter J. Stemp, 1991. "Optimal Weights in a Check‐List of Monetary Indicators," The Economic Record, The Economic Society of Australia, vol. 67(1), pages 1-13, March.
    4. Fang, Chung-rou & Lai, Ching-chong, 2002. "Targeting nominal income versus targeting price level: A target zone perspective," International Review of Economics & Finance, Elsevier, vol. 11(3), pages 229-249.
    5. Henderson, Dale W. & McKibbin, Warwick J., 1993. "A comparison of some basic monetary policy regimes for open economies: implications of different degrees of instrument adjustment and wage persistence," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 221-317, December.
    6. Robert Rennhack, 1991. "La Conducción de la Política Monetaria," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 28(83), pages 11-20.
    7. repec:bla:ecorec:v:67:y:1991:i:196:p:1-13 is not listed on IDEAS
    8. Läufer, Nikolaus K. A. & Sundararajan, Srinivasa, 1992. "International transmission of economic shocks: The case of mixed exchange rates in a three-country world," Discussion Papers, Series II 178, University of Konstanz, Collaborative Research Centre (SFB) 178 "Internationalization of the Economy".
    9. Fregert, Klas & Jonung, Lars, 1998. "Monetary Regimes And Endogenous Wage Contracts: Sweden 1908-1995," Working Papers 1998:3, Lund University, Department of Economics, revised 21 Apr 1999.

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