Real Wages and the Terms of Trade: Alternative Indexation Rules for an Open Economy

Abstract

There are two real wages in an open economy producing a product differentiated from those abroad: the nominal wage deflated by the price of the domestic good and by a price index composed of domestic and foreign goods. The producer responds to one real wage, while labor responds to the other.' When the terms of trade change, these two real wages diverge, so that fixing one real wage through indexation still allows the other real wage to vary. The paper will examine the effects of this interplay between the two real wages, since it is a key feature in the macroeconomic adjustment to economic disturbances.One suggestion commonly made is to limit wage indexation agreements to domestic prices alone by tying wages to the GM' deflator rather than the consumer price index.2 The proposal is attractive to many observers because it apparently offers a way of shielding the domestic economy from increases in the prices of imports, whether due to increases in foreign prices or the depreciation of the domestic currency. The paper will examine under what conditions this form of indexation is preferable to the traditional form of indexation to consumer prices. The choice of indexation rule will depend less upon how import prices change than upon how the terms of trade are affected by disturbances.Most previous studies of optimal wage indexation, including those of Gray (1976) and Fischer (1977b), have confined their analyses to closed -2--economies.3 The basic conclusions about indexation in such economies can be summarized as follows: monetary or aggregate demand disturbances call for full wage indexation since fixing real wages prevents output from