Sacrifice Ratio and Policy of Disinflation

Sacrifice Ratio and Policy of Disinflation –

Disinflation policy has been the objective of policy makers. But disinflation or reduction in inflation rate involves the cost to the society in terms of loss of output. This loss of output results from increase in unemployment. This implies, trade-off between inflation and unemployment suggested by short-run Phillips curve shown in fig.13.10.

The reduction in inflation rate from 10 percent to 8 percent causes 2 percent increase in unemployment rate. Increase in unemployment will bring loss of output. This amount of loss of output from a given reduction in inflation rate is measured by Sacrifice Ratio.

The Sacrifice Ratio is the ratio of cumulative loss of GDP (as a result of disinflation policy) to the reduction of inflation that is actually achieved.

Through short run Phillips curve implies that reduction in inflation causes increase in unemployment, but since increase in unemployment involves reduction in output, sacrifice ratio is generally measured in terms of loss of output caused by it. This loss or sacrifice of output can be compared with the benefits from reduction in inflation rate.

Studies of Empirical Data –

Studies of empirical data of the United States before the eighties conducted to estimate the quantitative relation between inflation and output found that sacrifice ratio was typically equal to 5 percent of one year’s GNP, that is, 5 percent of one year’s GNP had to be foregone to reduce inflation by 1 percent.

This estimate of sacrifice ratio made in other studies varies much. For example, a study for the eighties of the effects of disinflation policy pursued by Reagan- Volcker in the United States found that it resulted in very large unemployment but succeeded in reducing inflation. In an important study of this period Lawrence Ball has found that sacrifice ratio was 1.83 for the eighties which was much lower than the earlier estimate of 5. The success of reduction in inflation by Reagan and Volcker shows that credibility of policy makers plays an important role in reducing inflation.

If people believe that Government or Central Bank of the country is highly committed to disinflation policy and making sincere and tough measures to bring down inflation, their inflationary expectations will be reduced and this itself will reduce inflation. To win credibility the government has to make a drastic cut in its expenditure and also to reduce substantially the growth in money supply in the economy. It is these measures that helped to ensure credibility of Reagan and Volcker (then Chairman of Federal Bank of the US) and played an important role in reducing inflation during the eighties.

Sacrifice Ratio in Terms of Unemployment –

In terms of unemployment, sacrifice ratio means how much unemployment rate has to increase to reduce inflation by 1 percentage point. So, if we take 5 as sacrifice ratio in terms of GNP, then given the relation between unemployment and GNP we can find out the sacrifice ratio in terms of unemployment. For this we take the help of Okun’s Law which states that 1 percent point increase in unemployment causes 2 percent fall in GNP. This means that given 5 as sacrifice ratio in terms of GNP, then 2.5 percentage point increase in unemployment will cause fall by 5 percent of yearly GNP.

Using Sacrifice Ratio –

Using sacrifice ratio we can find out by how much and how long unemployment must rise to reduce inflation by certain percentage points. For example, given 5 as a sacrifice ratio in terms of GNP, then to reduce inflation by 4 percentage points, say from 8 percent to 4 percent, how much percent of yearly GNP will have to be foregone and how much increase in unemployment will occur. Since the sacrifice rate of 5 implies that for reducing inflation by 1 percentage point, 5 percent of yearly GNP will have to be given up.

According to Okun’s Law 1 percentage point of cyclical unemployment is associated with 2 percent of a year’s GNP, then to reduce 20 percent of a year’s GNP means increase in cyclical unemployment by 10 percentage points.

The policy of disinflation can take various forms. For example, rapid inflation or what is called ‘cold turkey’ solution can lower output by 10 percent each for 2 years (total of 20 percent decline of year’s GNP). Alternatively, a moderate policy of disinflation can be followed under which 5 percent fall in GNP per year for 4 years has to be obtained. Further, a more gradual policy of disinflation may be decided under which 2 percent fall in yearly GNP for 10 years period can be obtained. The policy maker has to make a choice among these forms of disinflation policy.