Inflation and Wage Indexation in the Postwar U.s

This paper examines the relationship between inflation and wage indexation in the postwar U.S. using data on the prevalence of cost-of-living adjustments in major collective bargaining agreements. I find that increases in inflation precede increases in wage indexation but reductions in inflation do not precede reductions in wage indexation. There is virtually no evidence that wage indexation affects inflation. JEL Classification No. E31 *Comments by an editor of the Review, an anonymous referee, and participants in the Macroeconomics Workshop at the University of Kentucky, especially James Fackler and Yoonbai Kim, are gratefully acknowledged. INFLATION AND WAGE INDEXATION IN THE POSTWAR U.S. For the postwar U.S., the rate of inflation is positively related to a measure of the prevalence of wage indexation: the number of workers covered by cost-of-living adjustment clauses as a percentage of the number of workers subject to major collective bargaining agreements (those covering 1000 or more workers). Figure 1 is a graph of this variable (INDEX) and the difference of the log of the annual average of the GNP deflator (INFL) scaled by a factor of 10. The two series are broadly similar in their movements over the period from 1957 to 1990. Both fell in the late 50s, though inflation began to rise in the early 60s while indexation did not begin to rise until the mid60s. Both series peaked once in the mid70s and again in the early 80s and both fell through much of the 80s. The correlation coefficient is .43. It seems likely that increased inflation would cause the prevalence of wage indexation to increase, but greater indexation might also cause higher inflation. Unfortunately, currently available methods are not fully capable of identifying causal relationships. It may be possible, however, to discover whether one variable precedes -i.e., "Granger causes" -the other. In 1 The series is available on an annual basis since 1957. For 1957-84, the source is Hendricks and Kahn (1985), Table 2-7. For later years the sources are various issues of Monthly Labor Review. Holland (1988) demonstrates that this variable is positively related to the responsiveness of union, nonunion, and economy-wide wage aggregates to price-level shocks. His findings suggest that there is implicit indexation for nonunion workers and also that the indexation variable is a suitable proxy for the overall degree of wage indexation in the economy -both explicit and implicit. this paper I find that increases in inflation precede increases in wage indexation but reductions in inflation do not precede reductions in wage indexation. There is virtually no evidence that wage indexation affects inflation. Theories Relating Inflation and Wage Indexation Higher inflation may lead to greater use of wage indexation. Danziger (1984) presents a model in which an increase in inflation uncertainty creates greater uncertainty about real wages for workers with nonindexed contracts and leads to greater wage indexation. Ball’s (1990) model implies that a higher rate of inflation produces greater uncertainty about the future direction of government policy and therefore greater inflation uncertainty. On the other hand, increased wage indexation may also lead to higher inflation. Fischer and Summers (1989) and Ball and Cecchetti (1991) show that increased indexation reduces the cost of inflation and thus may increase the time-consistent inflation rate. 2 Holland (1986) finds that the prevalence of wage indexation is positively related to lagged values of a measure of inflation uncertainty. A number of authors have found evidence of a positive relationship between the inflation rate and inflation uncertainty, a recent one being Evans (1991). Cecchetti (1987) finds that the use of incomes policies (and not inflation itself) during the 1960s and early 1970s led to substantial increases in the degree of adjustment of wages to inflation in union contracts. 3 Fischer (1983) presents evidence that indexation did not significantly affect the impact of the 1974 oil shock on the inflation rates of various countries.