9.5 Indexing and Its Limitations

Indexing is a crucial economic tool that adjusts wages, prices, and benefits for inflation. It helps maintain purchasing power and living standards as prices rise. However, indexing can also contribute to inflationary pressures and wage-price spirals.

Indexed financial instruments protect against inflation by linking returns to price indexes. While they maintain real value, they often offer lower nominal returns than non-indexed instruments. Central banks use monetary policy to control inflation and ensure indexing's effectiveness.

Indexing and Its Limitations

Indexing for inflation adjustment

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• Indexing adjusts economic variables (wages, prices, government benefits) to account for the effects of inflation
  • Keeps variables in line with the general increase in prices over time
• Wages can be indexed to inflation through cost of living adjustments (COLAs)
  • COLAs increase wages based on changes in the Consumer Price Index (CPI)
  • Maintains the purchasing power of workers' income as prices rise
  • Helps maintain real wages, which represent the actual buying power of earnings
• Prices of goods and services can be indexed to inflation by producers
  • Adjust prices based on changes in the CPI or other inflation measures (Producer Price Index)
  • Allows businesses to maintain profit margins as their costs increase
• Government benefits like Social Security payments are often indexed to inflation
  • Payments automatically adjust based on changes in the CPI each year
  • Helps recipients maintain their standard of living as prices increase

Effects of indexing on economy

• Indexing protects certain groups from the negative effects of inflation
  • Workers with indexed wages maintain their purchasing power over time
  • Recipients of indexed government benefits (Social Security) maintain their standard of living
• Indexing can contribute to inflationary pressures in the economy
  • Automatic wage increases lead to higher production costs for businesses
  • Businesses raise prices to maintain profit margins, leading to further inflation
• Indexing can create a wage-price spiral effect
  • Higher wages lead to higher prices, which lead to demands for even higher wages
  • Results in a self-reinforcing cycle of inflation that is difficult to break
• Indexing may not fully protect all groups from the effects of inflation
  • Those on fixed incomes (pensions) or with non-indexed investments suffer reduced purchasing power

Indexed vs non-indexed instruments

• Indexed financial instruments have returns linked to an index like the Consumer Price Index (CPI)
  • Treasury Inflation-Protected Securities (TIPS) and inflation-indexed bonds
  • Provide protection against inflation by adjusting the principal or interest payments based on changes in the index
  • Benefit investors by maintaining the real value of their investments over time
• Non-indexed financial instruments have returns not directly linked to an index
  • Traditional bonds and savings accounts
  • Face the risk of losing purchasing power during periods of high inflation
  • May offer higher nominal returns than indexed instruments during periods of low inflation
• Indexed instruments generally have lower nominal returns compared to non-indexed instruments
  • The inflation protection comes at the cost of potentially lower overall returns for investors
• Non-indexed instruments may be more suitable for short-term investments or during periods of low inflation
  • Investors may prefer the higher nominal returns when inflation risks are minimal

Monetary Policy and Price Stability

• Central banks use monetary policy to maintain price stability and control inflation
• Price stability helps ensure the effectiveness of indexing mechanisms
• Purchasing power parity is considered when comparing price levels across different countries
• Nominal wages are adjusted through indexing to maintain real wages and purchasing power