Indexation

Definition

Indexation is the process of adjusting the value of an economic variable, such as wages or prices, in response to changes in the cost of living or other relevant economic indicators. It is a mechanism used to maintain the real purchasing power of incomes and assets in the face of inflation.

5 Must Know Facts For Your Next Test

1. Indexation helps maintain the real value of incomes and assets by automatically adjusting them in line with changes in the cost of living.
2. Governments often use indexation to adjust social security benefits, tax brackets, and other government payments to protect against the erosion of purchasing power due to inflation.
3. Indexation can be applied to wages, pensions, rents, and other contractual payments to ensure that the real value of these payments is preserved.
4. The choice of index used for indexation, such as the Consumer Price Index (CPI) or another measure of inflation, can have significant implications for the effectiveness of the indexation process.
5. Indexation can help reduce the risk of wage-price spirals, where increases in wages lead to increases in prices, which then lead to further wage increases, creating a self-reinforcing cycle of inflation.

Review Questions

• Explain how indexation is used to maintain the real purchasing power of incomes and assets in the face of inflation.
  • Indexation is a mechanism that adjusts the value of economic variables, such as wages or prices, in response to changes in the cost of living or other relevant economic indicators. By automatically adjusting these variables to keep pace with inflation, indexation helps maintain the real purchasing power of incomes and assets. For example, if wages are indexed to the Consumer Price Index (CPI), they will be increased in proportion to the rise in the cost of living, ensuring that workers' real wages do not erode over time due to inflation.
• Describe the role of indexation in government policies and contractual payments.
  • Governments often use indexation to adjust social security benefits, tax brackets, and other government payments to protect against the erosion of purchasing power due to inflation. This helps ensure that the real value of these payments is preserved for the recipients. Additionally, indexation can be applied to wages, pensions, rents, and other contractual payments to ensure that the real value of these payments is maintained over time. The choice of index used for indexation, such as the CPI or another measure of inflation, can have significant implications for the effectiveness of the indexation process.
• Analyze how indexation can help reduce the risk of wage-price spirals and its implications for economic stability.
  • Indexation can help reduce the risk of wage-price spirals, where increases in wages lead to increases in prices, which then lead to further wage increases, creating a self-reinforcing cycle of inflation. By automatically adjusting wages and other contractual payments in line with changes in the cost of living, indexation can help break this cycle and promote greater economic stability. This is because workers' real purchasing power is maintained, reducing the pressure for further wage increases, and businesses can more accurately predict their costs, making it less likely that they will need to raise prices in response to wage hikes. As a result, indexation can contribute to a more stable and predictable economic environment, which is beneficial for both consumers and businesses.

Related terms

Cost of Living Index: A measure of the average change in prices paid by consumers for a basket of goods and services, used to track changes in the cost of living over time.

Inflation:

The sustained increase in the general price level of goods and services in an economy over time, which erodes the purchasing power of a currency.

Real Wages:

The purchasing power of wages, calculated by adjusting nominal wages for changes in the cost of living or inflation.