Sacrifice Ratio

In economics, the sacrifice ratio (SR) calculates the impact of curbing inflation on an economy's output of goods and services. It determines the percentage cost of actual production lost to every one percent decrease in inflation. The ratio helps acknowledge the gradual trade-off between inflation and economic growth. 

Since the ratio depicts the annual output an economy forgoes to reduce inflation, a low SR is always desirable. A higher SR means an economy had to give up greater output and suffer higher unemployment. Monetary authorities use SR to measure the impact of their fiscal policies on the economy.

• Sacrifice Ratio measures how changes in inflation rates affect economic production. 
• It gauges the cost of production loss per 1% reduction in inflation.
• Phillips curve proves the inverse relationship between inflation and unemployment. The sacrifice ratio presents the level of unemployment an economy has to face to bring down inflation.
• The sacrifice ratio of a country varies over time as per the independence of central banks, price stability, and monetary policies. 

Sacrifice ration measures the sacrifice an economy has to make in terms of production to bring down inflation. This ratio attained prominence throughout the late 1970s and early 80s for the US and other developed nations, where disinflation mainly caused major recessions. The reason was the use of contractionary monetary policies to control inflation and attain price stability.

Let’s see how monetary policies aimed at curbing inflation may adversely affect the economy. When prices rise due to demand exceeding supply, central banks hike interest rates to curtail consumer spending and encourage saving. With reduced spending, the demand drops and causes the prices to fall.

The fall in prices discourages companies from producing goods. As a result, production suffers, and output declines, causing an increase in unemployment. The cost of this drop of the potential output, brought on by fiscal policies aimed at minimizing inflation, is measured by SR.

This shows how disinflation is detrimental to a country’s economic growth, contrary to popular belief. Disinflation causes low demand, low production, and an inflated unemployment rate. It leads an economy to the verge of recession.

SR reveals the repercussions of monetary policies introduced by central banks to rein in inflation. Therefore, scrutinizing the past SR of a country assists the government in understanding the outcomes of their economic plans.

On that account, SR supports central banks to keep tabs on their fiscal regulations. This helps them implement relevant measures for boosting or reducing economic activity. In turn, it helps achieves a steady and low-level inflation rate that keeps up the employment rates and fosters economic growth. 

The surge or reduction in SR is related to inflation rate fluctuations and approach to labor and product markets. Nations with reduced inflation rates report an increased SR. While countries with more adaptable labor agreements, self-reliant central banks, stable rates, and reliable economic regulations possess a lower SR. 

Phillips Curve and Sacrifice Ratio

Monetary authorities aim toward low inflation and low unemployment. However, the Phillips curve establishes the existence of an inverse relationship between unemployment and inflation. The employment forgone to scale down inflation is disclosed by the SR.

Economist A.W. Phillips developed this economic model. According to this model, when central banks pursue contractionary monetary policies to stabilize inflation in the economy, it reduces demand and thereby the gross domestic product (GDP). This leads to a surge in unemployment.

The SR depicts the sacrifice in terms of unemployment that monetary authorities have to make to pull down inflation. This sacrifice has to be made in the short run to reduce inflation expectations in the long run. Lower inflation expectation will keep inflation in check without increasing unemployment. Since expectations influence inflation, the shape of the Philips curve determines the size of the SR. 

When inflation reduces from I2 to I1, unemployment increases from U1 to U2. The movement from point A to B depicts the sacrifice to be made to reduce inflation. When inflation expectations reduce in the long run, the Phillips curve PC2 is formed. Finally, point C exhibits a time when inflation reduces without causing unemployment.

SR gauges the cost of output lost per 1% reduction in the inflation rate. The numerator of SR represents fluctuations between in real output. At the same time, the denominator connotes the variation in inflation at peak and trough.

Suppose a country's inflation gets reduced by 2% over the last year, resulting in a decline in the GDP or output of goods and services. The cost of the production loss comes out to be 10%. In this case, the SR is:

It means for every 1% reduction in inflation, an economy must sacrifice the 5% of annual output.

This has been a Sacrifice Ratio in Economics & its Meaning. Check out the sacrifice ratio, its formula, & examples, along with the Phillips curve. You may also have a look at the following articles to learn more –

• Welfare Economics
• Classical Economics
• Top 10 Economic Indicators