RDP 8909: Optimal Wage Indexation, Monetary Policy and the Exchange Rate Regime 1. Introduction

The deterioration in macroeconomic performance of many of the industrial economies since the early 1970's has been difficult both to explain and to counteract. This paper presents a cross-country study which examines this deterioration in terms of the degree of wage indexation, the choice of exchange rate regime, and the effects of various shocks that have buffeted these economies during this time. To my knowledge, this is the first attempt to address all of these issues empirically.^[1]

While macroeconomic performance, particularly in the labour market, has been generally poor over this period, some countries have fared better than others. A common explanation for this divergence in performance is that those countries with the most flexible labour market institutions have been in the best position to withstand the shocks of the period. The theoretical rationale for this explanation can be found in the early literature on the macroeconomics of wage indexation (Gray (1976), Fischer (1977)), which found that wage indexation stabilizes output around a desired level in the presence of demand shocks, but destabilizes output in the face of supply shocks. The optimal (labour market clearing) degree of wage indexation therefore depends on the relative prevalence of those shocks.^[2]

It is well recognized that sticky real wages in the presence of supply shocks can lead to sub-optimal macroeconomic outcomes. What is not generally appreciated, however, is that the choice of an optimal exchange rate regime ^[3] can partially offset the negative consequences of that rigidity. Consequently, the optimal degree of wage indexation is a function not just of the relative strength of demand and supply shocks but also of the degree of nominal exchange rate flexibility. Equivalently, the optimal exchange rate regime is a function of the degree of wage indexation.^[4]

Two issues are worth noting. The first is that the choice of exchange rate regime and degree of wage indexation are simultaneous decisions, made conditional on such factors as the presence of certain shocks. Under decentralized decision making, it is not obvious that ex-post optimal outcomes will occur, given the available information at the time the decisions are made.

The second issue is that although the period since 1973 is often characterized as that of “generalized floating” exchange rates, exchange market intervention has occurred on a fairly regular, albeit ad hoc basis. Governments, or central banks, might conceivably have chosen the degree of flexibility in the exchange rate to offset perceived labour market rigidities. Conversely, the behaviour of wage setters might have been a function of the existing exchange rate regime.

In this paper I employ a simple neo-classical macroeconomic model to investigate whether, over the period 1973 to 1988, the degree of wage indexation in several economies was optimal given their chosen exchange rate regime and the shocks they experienced. (Equivalently, one can ask whether the choice of exchange rate regime was optimal, given those shocks and the degree of wage indexation). The countries examined are the G7 countries ^[5] plus two small open economies, Australia and Austria. The paper is organized as follows. The model is outlined in sections 2 and 3 with empirical questions being addressed in sections 4 and 5. Section 6 contains a summary and some concluding remarks.

Footnotes

In a recent paper, Kaufman and Woglom (1987) estimate the optimal degree of wage indexation for a number of countries, but do not address the question of the exchange rate regime. Aizenman and Frenkel (1985), Turnovsky (1987) and Devereaux (1988) present exhaustive theoretical treatments of these issues. Recent contributions to the literature on comparative macroeconomic performance include Bruno and Sachs (1986), Metcalf (1987), Alogoskoufis and Manning (1988) and Gordon (1988). [1]

More precisely, since the shocks are stochastic and unobservable, but are assumed to have a known variance, the ex-ante optimal degree of wage indexation (which is contingent on the observed price level) depends on the relative magnitude of those variances. [2]

I define an exchange rate regime to be the degree of nominal exchange rate flexibility. [3]

Specifically, monetary policy can be used to obtain a degree of nominal exchange rate flexibility. The optimal degree of flexibility, given the existence of a certain degree of wage indexation, is that which leads to the attainment of the labour market clearing real wage. Under complete wage indexation, however, monetary policy cannot alter the real wage, and the optimal degree of exchange rate flexibility is indeterminate. [4]

These are Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. [5]