Wage Indexation and the Effect of Inflation Uncertainty on Employment:An Empirical Analysis

Abstract

In his Nobel Lecture, Milton Friedman (1977) argued that the greater uncertainty associated with higher inflation leads to a misallocation of resources because of shorter duration of contracts and reduced efficiency of the price system. The result is reduced economic growth and, possibly, more unemployment (i.e., a positively sloped Phillips curve) over the fairly long term. In a subsequent article, Maurice Levi and John Makin (1980) found a significant negative impact of inflation uncertainty on employment growth. Evidence of a similar nature was reported by Yakov Amihud (1981), Makin (1982), and Ronald Ratti (1985), while Donald Mullineaux (1980) found a significant positive effect of inflation uncertainty on the rate of unemployment and a negative effect on industrial production. Given the substantial body of empirical literature linking higher inflation to greater inflation uncertainty, this provides support for Friedman's hypothesis.' Friedman also noted, however, that in the very long run, institutions should adapt to an inflationary economy in a way that offsets much of the real effect of higher inflation. An example of such adaptation is more widespread indexation of wages. Levi and Makin recognized the potential impact of indexing but did not attempt to estimate it: To the extent that inflation uncertainty persists and causes lower employment, our results tend to support the case for a wider use of indexing of nominal contracts, which should reduce the impact of uncertainty felt on the real (p. 1026). The purpose of this article is to estimate the impact of inflation uncertainty on employment, while also considering the second-round effects of labor market adjustments designed to reduce the risk associated with inflation uncertainty. Despite the limited scope of the data, an increase in the prevalence of wage indexation in major collective bargaining contracts is taken to indicate a general increase in the responsiveness of nominal wages to inflation surprises.2 In other words, as the percentage of contracts with indexation clauses increases, the degree to which already indexed wages adjust to price level changes is assumed to increase. Furthermore, the effect is assumed to extend beyond the sector of the labor market covered by major collective bargaining agreements to smaller union contracts and even to nonunionized labor. This article proceeds as follows. Section I discusses the measurement of inflation uncertainty and the level of wage indexation and estimates the impact of inflation uncertainty on indexation in the United States for the period 1961-83. Section II examines the impact of inflation uncertainty, indexation, and unanticipated inflation on employment. Section III presents the results of simulations designed to illustrate how increased wage indexation offsets at least part of the adverse *Department of Economics, University of Kentucky, Lexington, KY 40506. Helpful comments from R. W. Hafer, Ronald Ratti, Richard Sheehan, Daniel Thornton, two referees, and the participants in seminars at the Board of Governors of the Federal Reserve System, Claremont College, Georgia State University, and the University of Kentucky are gratefully acknowledged. This research was conducted at the Federal Reserve Bank of St. Louis with assistance from Jude Naes. The views expressed do not necessarily reflect those of the Federal Reserve Bank of St. Louis or the Federal Reserve System. 'My 1984 article provides a review of the literature linking higher inflation to greater inflation uncertainty. 2Formal indexing typically applies only to contracts in the unionized sector-less than 25 percent of the U.S. labor market. This measure should serve the purpose at hand, however, since the behavior of union wages influences the wages of other workers, and since adjustments to greater inflation uncertainty in the unionized sector can be expected to occur at roughly the same time as adjustments in other sectors of the labor market.