Optimal monetary policy and alternative wage indexation schemes in a model with interest-sensitive labor supply

This paper examines the implications for wage indexation behavior and for optimal monetary policy of extending macroeconomic contracting models to settings in which wagesetters are influenced by the real rate of interest. It is demonstrated that, in such a setting, interest-rate-contingent monetary policy may become impotent as a tool for real sector stabilization if wages are indexed optimally to the real interest rate or to a real variable that provides an indirect observation of the real rate. In addition, it is shown that Gray's result concerning full wage indexation to unanticipated inflation in the absence of productivity disturbances does not generalize to this type of environment, nor does the result of Fethke and Jackman that optimal indexation precludes a need for the monetary authority to consider supply shocks when formulating an optimal combination policy.