Any attempt to reduce inflation leads to recession. The amount of output lost through cold turkey and gradualism is explained with the help of sacrifice ratio.
It is the ratio of cumulative percentage loss of GDP (due to disinflationary policy) to the reduction in inflation that is actually achieved.
Or Sacrifice Ratio = Loss of level of output/Every percentage fall in rate of inflation
Due to inflation, aggregate demand (AD) falls and therefore output falls. There is loss of output.
Inflation rate is decreased from 10 to 4% over 3 years at the cost of output 10%, 8% and 6% below the potential output (full employment) in first, second and third year, respectively.
Total loss of GDP = 24% (10 + 8 + 6)%
Decrease in Inflation Rate = 6% (10 – 4)%
Sacrifice Ratio = 24/6 = 4
that is 4:1
It implies for every 1% of decrease in inflation rate 4% of GDP has to be scarified
Thus, the sacrifice ratio is the cost of fighting inflation, or the cost of disinflation.
According to the Phillips curve:
There exists a tradeoff between output and inflation. The short run Phillips curve is quite flat. Within a year, one point of extra unemployment reduces inflation by about 0.5 point, holding inflation expectations constant.
In other words, 1-point reduction in inflation costs 2-points of unemployment.
According to Okun’s law:
2 point of unemployment costs 4 per cent of output, that is, loss of output worth 4%
Thus, according to Okun:
The sacrifice ratio is 4
However according to Ball:
Sacrifice ratio will be 2.39
During disinflation, expected inflation falls. This will drop the sacrifice ratio to 2.39.
Thus, we find that the sacrifice ratio varies depending on the time, place and methods used to reduce inflation.
Disinflation/Reduction in inflation can be less costly when:
1. The policy is announced in advance
2. Deceleration is gradual
3. Policy of disinflation is credible
4. Importance of πe is more in determining current inflation (π)
5. Response of price and wages to demand conditions are very high.