ABSTRACT
Wage indexation affects macroeconomic stability through its impact on the variability of output and prices. There are two predominant views on the role of wage indexation. The first sees it as minimizing the distortions and inequities that arise from high and variable inflation. According to this view, wage indexation stabilizes output and, in particular, reduces the cost of policies designed to reduce inflation. The second view is that indexation destabilizes activity by reducing the responsiveness of the economy to disturbances requiring adjustment to real wages. A cornerstone of the result is the assumption that employment is determined by labour demand in situations of disequilibrium. Thus, without indexation, a disturbance that reduces supply raises the price level, which, in turn, reduces real wage costs, thereby partially offsetting the effect of the supply shock on labour demand and output. Alternatively, the fall in the real wage rate will decrease employment, thereby exacerbating the impact of the supply shock on output.
