We present a new theory of wage adjustment, based on worker loss aversion. In line with prospect theory, the workers …' perceived utility losses from wage decreases are weighted more heavily than the perceived utility gains from wage increases of … equal magnitude. Wage changes are evaluated relative to an endogenous reference wage, which depends on the workers' rational …

Empirical and institutional evidence finds considerable time variation in the degree of wage indexation to past … build a DSGE model with endogenous wage indexation in which utility maximizing workers select a wage indexation rule in … aggregate demand shocks dominate output fluctuations. The model's equilibrium wage setting can explain the time variation in …