Indexation of the Minimum Wage with Rational Expectations

This paper considers the possible employment effects of reforming minimum-wage policy to incorporate indexation of the nominal minimum wage .The analysis assumes that both the demand for the labor services of minimum-wage workers and the setting of the nominal minimum wage rate under existing policy depend in part on rational expectations of future average wage rates. The analysis implies that, if the indexation ratio of the nominal minimum wage to the recent-past average wage rate were large relative both to the level and trend of the expected rate of average wage inflation and to the existing relative minimum-wage target, indexation would decrease the average level over time of minimum-wage employment. The analysis also implies that, if the year-to-year variation in expected wage inflation were large relative to the year-to-year variation in unexpected wage inflation, indexation would increase the year-to-year variation in minimum-wage employment.