Optimal Wage Indexation, Monetary Policy and the Exchange Rate Regime

The optimal (labour market clearing) degree of wage indexation is derived from a simple neo-classical model, and is shown to be conditional on the variance of a number of supply and demand shocks, as well as the exchange rate regime. The model is estimated for nine industrial countries over the period 1973 through 1988. In no case was the actual degree of wage indexation found to be significantly greater than the optimum, suggesting that mechanisms other than “excessive wage indexation” were responsible for the increases in unemployment in these countries over this period.