Definition: Indexation is a method by which the prices, wages, and contracts are partially or wholly compensated for any change in the general price level. Indexation is not actually a method to control inflation, but rather is used to adjust monetary incomes with a view to minimizing the undue gains and losses suffered by the different sections of the society because of inflation.
Inflation is complex and controlling it involves the risk of worsening the unemployment problem. Therefore, the economists argue that if it is not advisable to control inflation, then its adverse effects on different sections of the society can be minimized by the method called indexation. The purpose of indexation is to manage the lack of social contentment (dissatisfaction) among people and make inflation easier to live with.
Indexation of wages is the widely used in the countries where the wage contracts are long-term, and inflation continues to persist for long. In such condition, the workers are compensated for the loss of real income, in case the inflation becomes unavoidable. Two commonly used wage indexation systems are:
- Tying the wages to cost of living index, i.e. Consumer Price Index (CPI)
- Making periodic scheduling of the wage rise after CPI increases or goes up by a certain percentage.
Although the economists recommend the indexing of wages, taxes, debts and other long-term contractual payments, the government is skeptical about its feasibility and practicability due to the following reasons:
- In the case of frequent supply shocks, an unexpected decline in the supply, the adjustment in the indexation is not feasible.
- The economy being complex, is composed of several interlinked and interrelated prices, a reasonable indexing of all prices to the satisfaction of all is an extremely difficult task.
- It is found to be politically undesirable because the government feels that indexation does not control inflation, but rather provides a base for it to perpetuate.
In India, the wage compensation is given in the form of “Dearness Allowance” or “DA”. DA is the compensation given for the loss of purchasing power of the nominal wages due to inflation. Dearness allowance to workers in public sector undertakings is linked to the price index (CPI) and is given after every 8% point rise in the index.