Sacrifice ratio

What is the sacrifice ratio, and how might it be affected by the credibility of monetary policy announcements?

The term ’sacrifice ratio’ was covered in the chapter on inflation. The Sacrifice Ratio – measures how much of a year’s real GDP that must be foregone to reduce inflation by 1% point. There are many variations in this estimate but a typical estimate is about 5. This means that for every percentage fall in inflation, output must fall or there must be a 5% sacrifice in output. Let’s say that the monetary policy is to lower inflation from the current 4% to 2%.

In order to lower inflation, a contractionary MP is adopted. This as you know will cause output to fall (and unemployment to rise). If people do not believe that the monetary policy will really be carried out to lower inflation (as it will result in unemployment), their expectations of price will not change and therefore there will be no shift in the Phillips curve (since expected inflation does not change). Hence, the contractionary MP when adopted causes actual price to fall (and be different from expected price) - there is now a movement along the same Phillips curve and you will see that the fall in inflation results in an increase in unemployment (or a decrease in output), so the sacrifice ratio is positive. The more credible the monetary policy announcement is, people’s expectations of price will change immediately. They know that price will fall for sure and therefore change their expectations accordingly.

So the Phillips curve shifts down (as expected price falls) and at the new equilibrium, actual price and expected price are the same, and unemployment remains at the natural rate, which means that there is no change in output either. So the sacrifice ratio is zero. The more credible the monetary policy announcement, expectation of price will change accordingly and the Phillips curve will shift resulting in a smaller sacrifice ratio.