Sacrifice Ratio: Videos & Practice Problems

The sacrifice ratio in macroeconomics measures the cost of reducing inflation in terms of lost GDP. Specifically, it indicates the percentage of GDP that must be sacrificed to decrease inflation by 1%. For example, if reducing inflation by 1% results in a 3% decrease in GDP, the sacrifice ratio is 3. This concept is crucial for policymakers as it highlights the trade-offs involved in implementing contractionary fiscal or monetary policies to control inflation. Understanding the sacrifice ratio helps in evaluating the economic impact of such policies on growth and employment.

Expected inflation significantly impacts the short-run Phillips curve. When expected inflation increases, the short-run Phillips curve shifts to the right, indicating higher inflation for any given level of unemployment. Conversely, if expected inflation decreases, the curve shifts to the left. This shift occurs because higher expected inflation leads to higher wage demands and price settings by firms, which in turn raises actual inflation. Therefore, managing expectations about inflation is crucial for policymakers aiming to control inflation without causing excessive unemployment.

Contractionary fiscal policy reduces inflation by decreasing the money supply and aggregate demand. This is typically achieved by selling Treasury bills, which reduces the money supply and increases interest rates. Higher interest rates discourage investment and consumption, leading to a decrease in aggregate demand. As aggregate demand falls, the price level decreases, thereby reducing inflation. However, this policy also results in lower GDP and higher unemployment, illustrating the trade-offs involved in controlling inflation.

In the long term, reducing inflation leads to a leftward shift in the short-run Phillips curve due to lower expected inflation. Initially, contractionary policies increase unemployment and reduce GDP. Over time, as inflation expectations adjust downward, the short-run Phillips curve shifts left, resulting in a new equilibrium with lower inflation and a return to the natural rate of unemployment. This long-term adjustment highlights the importance of managing inflation expectations to achieve stable economic conditions.

Nominal and real interest rates are closely related to expected inflation. The nominal interest rate is the stated rate on a loan, while the real interest rate is adjusted for inflation. The relationship can be expressed as:

$r=i-\pi$

where $r$ is the real interest rate, $i$ is the nominal interest rate, and $\pi$ is the expected inflation rate. For example, if a bank wants a real return of 5% and expects 2% inflation, it will set the nominal rate at 7% to achieve the desired real return.