Wage indexation, employment and inflation

Price versus productivity-indexing is considered in a model of monetary pol icy with incomplete information and wage bargaining. In a perfectly price-i ndexed economy, the inflationary bias due to lack of credibility is elimina ted. However, productivity-indexing is more appropriate to dampen macroecon omic fluctuations that are caused by real disturbances, We show that produc tivity-indexing alone guarantees both price and employment stability, provi ded the government's reputation is good enough and the union's bargaining p ower is not too strong. This reduces the degree of price indexation as the union becomes weaker and the government's reputation improves. Productivity -indexing is desirable with volatile productivity processes and weak unions .