What is 'Indexation'

Indexation is a system or technique used by organizations or governments to connect prices and asset values to inflation. This is done by linking adjustments made to the value of a good, service or other metric, to a predetermined index. Indexation requires the identification of a price index and whether a linking the value to the price index, will accomplish the organization's goals. Indexation is most commonly used with wages in a high inflation environment.

BREAKING DOWN 'Indexation'

Businesses may use indexation to match an employee's salary to the inflation rate, meaning that an increase in the inflation rate over a period of time, will lead to an increase in salary. This particular type of indexation is called a cost of living increase (COLA). Indexation is a pre-specified process, meaning that all parties involved are typically aware of how the link works.

In the above example, the use of indexation in theory can mitigate the impact of inflation against a workers salary. This way jobs and career paths remain relevant and in stride with fluctuations of overall inflation. There are still possibilities for economic changes to force some disparity between salaries and the pace of inflation.

How Indexation is Applied to Different Types of Assets and Payments

Indexation might be used by governments as a means of control over the economy as a way to potentially alleviate the negative effects inflation can have.

Various assets and values might be subject to indexation. Some countries might apply indexation on certain types of tax payments at varying periods. For instance it might be applied to debt mutual funds that have been held for a certain minimum of time before being sold. In such a case, the original purchase price is adjusted for inflation when calculating long term capital gains that will be taxed when those debt funds are sold. This can lead to a discount on taxes after the transaction for the seller of such assets.

Indexation might also be applied to pension funds in order to reassure participants that their assets will keep pace with inflation. That way the value of those assets do not erode as time passes.

Life insurance companies might offer their clients policies that include terms for indexation, which may promise a payout that is adjusted for inflation, however the premiums for such plans can be higher with annual increases. Such a product may raise concerns about consumers overspending on premiums especially for periods when inflation is minimal and below the rate of increase charged for indexation.

RELATED TERMS
  1. Inflation

    Inflation is the rate at which prices for goods and services ...
  2. Price Inflation

    Price inflation is the increase in a collection of goods and ...
  3. Total Return Index

    Total return indexes include any dividends in the calculation ...
  4. Index Fund

    An index fund is a portfolio of stocks or bonds that is designed ...
  5. Inflation Derivatives

    Inflation derivatives are derivative used by investors to hedge ...
  6. Inflation Accounting

    Inflation accounting is a special accounting technique used during ...
Related Articles
  1. Insights

    Inflation's Impact on Stock Returns

    Learn about the impact inflation can have on stock returns. Find information on what types of stocks perform during times of high inflation or low inflation.
  2. Trading

    Coping With Inflation Risk

    Inflation is less dramatic than a crash, but it can be more devastating to your portfolio.
  3. Insights

    Inflation And Economic Recovery

    Inflation impacts the costs of every facet of the economy. Discover how it can help or hinder the economic recovery.
  4. Investing

    Timeless Ways To Protect Yourself From Inflation

    Inflation is a natural part of modern life, but there are some time-tested ways to inflation-proof your assets.
  5. Investing

    The Pros and Cons of Indexes

    Learn about the advantages and disadvantages of stock indexes and passive index funds. Discover how there is an opportunity cost to using index funds.
  6. Trading

    Index Options: A How-To Guide

    Index options, financial derivatives that derive their value from a stock index, can provide stability and peace of mind for less risky investors.
  7. Insights

    Should You Worry About the U.S Inflation rate?

    Understand how inflation is measured, how U.S. inflation compares to other countries, and if investors should be concerned with rising inflation.
  8. Investing

    The Hidden Flaws of Index Investing

    Index investing isn't always better than active investing. Here's why.
  9. Insights

    9 Common Effects of Inflation

    Is inflation ever good? If you like your job it is.
RELATED FAQS
  1. What is inflation and how should it affect my investing?

    The rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss ... Read Answer >>
  2. How Do I Find Mutual Funds That Track Indexes?

    Two good sources for finding index funds are Fidelity Investments and Vanguard. Read Answer >>
  3. What does the current cost of living compare to 20 years ago?

    Find out how inflation has affected the dollar since 1994, and how the cost of living has changed above and beyond what can ... Read Answer >>
  4. How does inflation affect fixed-income investments?

    Learn about the ways inflation can harm fixed-income investments. Find out how to monitor the impact of inflation using common ... Read Answer >>
  5. What's the highest year-over-year inflation rate in the history of the U.S.?

    Learn about periods with the highest inflation in U.S. history and the mandated role of the U.S. Federal Reserve in controlling ... Read Answer >>
  6. How Can Inflation Be Good for the Economy?

    Find out why some economists and public policy makers believe that inflation is a good, or even necessary, phenomenon to ... Read Answer >>
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center