Indexation

Published Jan 3, 2023

Definition of Indexation

Indexation (i.e., escalation) is the process of adjusting the price of a financial instrument or contract (e.g., wages) to account for changes in the value of money over time. That means it is a way to protect the purchasing power of a financial instrument or contract by adjusting it for inflation or different cost in different countries or regions.

Example

To illustrate this, let’s look at an example. Suppose you have a fixed-term loan with a principal of USD 10,000 and an interest rate of 5%. The loan is set to be repaid in 5 years. However, due to inflation, the purchasing power of the USD 10,000 decreases over time. To protect the lender from this, the loan contract is indexed. That means the interest rate is adjusted to account for inflation.

Similarly, let’s say a worker earns USD 30,000 per year. Now, if inflation is 5%, that wage loses part of its purchasing power every year. To make up for this, the trade unions often negotiate an indexation of wages, where the wages escalate (i.e., grow) in line with a certain index that tracks the cost of living (e.g., CPI). If they don’t, workers essentially suffer real wage cuts every year because the purchasing power of their compensation decreases.

Why Indexation Matters

Indexation is important because it helps to protect the purchasing power of a financial instrument or contract. Without indexation, the value of money decreases over time due to inflation. That means the lender would be at a disadvantage because the amount of money they receive at the end of the loan term would be worth less than the amount they lent out. The same also holds true for workers and their wages.

It is important to note that in most cases, indexation is agreed upon in advance. Meaning that all parties involved are aware of the process and have agreed to it prior to signing the contract.