Endogenous Wage Indexation and Aggregate Shocks

Empirical and institutional evidence finds considerable time variation in the degree of wage indexation to past inflation, a finding that is at odds with the assumption of constant indexation parameters in most New-Keynesian DSGE models. We build a DSGE model with endogenous wage indexation in which utility maximizing workers select a wage indexation rule in response to aggregate shocks and monetary policy. We show that workers index wages to past inflation when output fluctuations are primarily explained by technology and permanent inflation-target shocks, whereas they index to trend inflation when aggregate demand shocks dominate output fluctuations. The model’s equilibrium wage setting can explain the time variation in wage indexation found in post-WWII U.S. data.