1997 Reports

Indexation, Inflation and Central Bank Independence

Pecchi, Lorenzo; Piga, Gustavo

We provide a model which analyzes the effect on equilibrium inflation of different degrees of labor-market indexation. We show that time-inconsistency models cannot account fully for the stylized fact of policy-makers distaste for indexation clauses. In our model the Central Bank and the government interact, pressed by lobbying groups for redistribution through unexpected inflation. We find that inflation increased as indexation increases. The cornerstone of our model is that indexation changes the incentives of the various interest groups that press the government thereby changing the equilibrium inflation rate. A corollary of our model is that Central Bank independence is going to be successful only in societies with anti-inflationary preferences, reversing the traditional causality from independence to inflation.