Islands, indexation and monetary policy

This paper develops a synthesized macroeconomic model that incorporates the local‐global informational asymmetries of an “islands” economy into a setting characterized by endogenous wage indexation. In such an economy, agents are unable both to filter out the separate influences of demand and supply shocks on observed output prices and to distinguish between the separate price effects of local and aggregate disturbances, so that optimal wage indexation depends upon both the variances of supply and demand disturbances and the information‐conditioned forecasts of agents. As a result, optimal monetary policy generally depends upon the variances of local and aggregate supply and demand.