This paper shows how economic interdependence affects wage indexation decisions when monetary authorities do not observe stochastic disturbances. Under a managed exchange rate, atomistic wage setters in interdependent nations will
choose the same degree of indexation as they would in a small open economy.
Under a flexible exchange rate, the likelihood rises that they will choose a
lower degree of indexation than their counterparts in a small open economy as
the degree of interdependence rises, as the variance of money demand shocks
rise relative to supply shocks, and as supply curves steepen. Finally, wage
indexation choices are more likely to be strategic complements as the degree of
interdependence rises and as the variance of money demand shocks rises relative
to supply shocks.
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Last update: July 19, 2001