Index Wage And Inflation In Reputation Game Theory Framework

Inflationary bias, which was first introduced by Kydland and Prescott (1977), stems from the time inconsistency problem as the nominal rigidity (along with other factors) increases the policymaker's incentive to reduce unemployment by exploiting the short-run trade off between inflation and unemployment. One way to avoid the undesirable outcome of inflationary bias is by pre-commitment to rules [Barro and Gordon, (1983)]. Another way is simply to reduce the nominal rigidity by increasing the wage indexation. Although both the effects of wage indexation and the effects of pre-commitment to rules were widely studied in recent years, the link between the two still remains rather ambiguous.The macroeconomic effects of wage indexation have been studied since the early 1970s. It was found that indexation might have two opposing inflationary effects. On the one hand, indexation can be inflationary since the higher the indexation, the lower the cost deriving from inflation, hence policymakers would have lower incentive to reduce inflation. This was explicitly stressed by Fischer and Summers (1989) model. On the other hand, indexation reduces the nominalrigidity in the economy; hence it also reduces the incentive of the policymakers to inflate. Thus, indexation could be considered as anti-inflationary. In these frameworks, the optimal degree of indexation was examined mainly in situations when the policymakers conducted a discretionary policy without taking into account the effects of their reputation for dependability.This paper differs from the above works mainly in the monetary regime in which policymakers act. In particular, it implements the inflation target approach, which was first introduced by Barro (1986) and later developed by Cukierman and Liviatan (1991). In this framework the policymakers use pre-commitment to an explicit inflation target at the beginning of the period, before the nominal wage contracts are signed, in order to reduce the inflationary bias. Since there is uncertainty regarding the policymaker's ability to commit, the optimal strategies of both the workers (which embodies their inflationary expectations into wage contracts) and the policymakers are mostly determined by the level of the policymakers' reputation. In the inflation target framework, Cukierman and Liviatan (1991) and Cukierman (2000) have shown that when the level of indexation is fixed, there is a clear negative relationship between the inflation target picked by the dependable policymaker and her reputation (i.e., highreputation leads to a low inflation target) since she is compromised regarding her price stability objective and accommodates to inflationary expectations to avoid deep recession. The questions remain are how reputation affects the optimal choice of the government and the public in the game between them, whether there is any equilibrium in this game, how many equilibriums is the game have and as a consequence what is the total effect of the former on inflation targets?...