Wage Indexation

What wage level a firm is supposed to give to workers is determined by the wage contract. Wage contracts are set by the mutual consultation of firms and workers but the weak point about such contracts is that they are set for a longer period of time. Before firms and workers enter into any labor contract, price level that is going to prevail over the period of time for which the contract is getting constructed, is not known and so they make expectations about the price level and wage contracts are fixed on that basis which are not subjected to change.

What if the actual price level happens to be different from the expected one?

If the expected price level is lower than the actual price level, then given the amount of wage in the wage contract, nominal wage does not change but the real wage goes down. So the workers may suffer large cuts in their living standards. If the actual price level turns out to be lower than expected, then the real wage may go up sharply and some firms may go bankrupt.

To reduce that effect to some extent, one way is to set the wage contract for a shorter period of time so that wages could be adjusted simultaneously with the change in the price level. Another way is Wage Indexation. The process of adjusting the nominal wages quickly in response to the change in the price level is known as Wage Indexation. It’s a mechanism through which wages automatically respond to a change in price so that real wages remain constant.

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