Indexation

Definition

Indexation is the practice of adjusting a value, such as wages or prices, in response to changes in a general price index. It is a mechanism used to maintain the purchasing power of income or assets in the face of inflation.

5 Must Know Facts For Your Next Test

1. Indexation is a key tool used to protect the real value of incomes, pensions, and other payments from the erosive effects of inflation.
2. Indexation can be applied to wages, social security benefits, pensions, rents, and other contractual payments to ensure they maintain their purchasing power.
3. The most common index used for indexation is the Consumer Price Index (CPI), which measures the average change in prices of a basket of consumer goods and services.
4. Indexation helps to prevent the real value of incomes from being eroded by inflation, promoting economic stability and protecting the standard of living.
5. The degree of indexation can vary, with some systems fully indexing to the CPI and others only partially indexing to mitigate the inflationary impact.

Review Questions

• Explain how indexation is used to measure changes in the cost of living.
  • Indexation is a key mechanism for measuring changes in the cost of living, as it involves adjusting wages, benefits, and other payments in response to changes in a price index like the Consumer Price Index (CPI). By linking incomes and payments to the CPI, indexation helps maintain the purchasing power of individuals and households as the general price level rises due to inflation. This ensures that the real value of their income is preserved, even as nominal prices increase over time.
• Describe how indexation can be a cause of inflation in various countries and regions.
  • Indexation can contribute to the persistence of inflation in certain countries and regions. When wages, prices, and other payments are automatically adjusted to keep pace with inflation, it can create a self-reinforcing cycle where rising prices lead to higher incomes, which in turn drive further price increases. This wage-price spiral can become entrenched, making it difficult to break the inflationary cycle. Additionally, indexation can lead to a loss of competitiveness if it causes wages and prices to rise faster than in other countries, potentially leading to trade imbalances and further inflationary pressures.
• Evaluate the role of indexation in maintaining the purchasing power of incomes and assets in the face of inflation.
  • Indexation plays a crucial role in preserving the real value of incomes and assets in the face of inflation. By automatically adjusting wages, benefits, and other payments in line with changes in a price index like the CPI, indexation ensures that the purchasing power of these incomes is maintained over time. This helps protect the standard of living of individuals and households, promoting economic stability and social cohesion. However, the degree of indexation can vary, and partial indexation may be used to mitigate the inflationary impact. Additionally, the widespread use of indexation can contribute to the persistence of inflation in certain countries and regions, underscoring the need for a balanced approach to its implementation.

Related terms

Cost-of-Living Adjustment (COLA):

A periodic increase in wages, salaries, or benefits to offset the effects of inflation and maintain the same purchasing power.

Consumer Price Index (CPI):

A measure of the average change over time in the prices paid by consumers for a basket of consumer goods and services.

Inflation:

The sustained increase in the general price level of goods and services in an economy over time.