Sacrifice Ratio In Economics Meaning Formula Examples

Sacrifice Ratio in Economics Meaning

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Since the ratio depicts the annual output an economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more 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 policiesFiscal PoliciesFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more on the economy.

Key Takeaways

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 Ratio Explained

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 policiesContractionary Monetary PoliciesContractionary monetary policy is the type of economic policy that is basically used to deal with inflation and it also involves minimizing the fund’s supply in order to bring an enhancement in the cost of borrowings which will ultimately lower the gross domestic product and moderate or decrease inflation too.read more to control inflation and attain price stability.

Let’s see how monetary policiesMonetary PoliciesMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more 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 growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more, contrary to popular belief. Disinflation causes low demand, low production, and an inflated unemployment rateUnemployment RateThe unemployment rate formula calculates the share of people who are not working or are jobless of the total employed or unemployed labour force and is depicted as a percentage. Unemployment Rate = Unemployed People / Labor Force * 100 read more. It leads an economy to the verge of recession.

Need for Calculating Sacrifice Ratio

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 rateInflation RateThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100.read more 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 curvePhillips CurveThe Phillips curve states that there is an inverse relationship between inflation and the unemployment rate, i.e., the higher the inflation rate of the economy, the lower the unemployment rate, and vice versa. William Phillips developed this economic concept, which has been proven in all major world economies.read more 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)Gross Domestic Product (GDP)GDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period.read more. 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 expectationsInflation ExpectationsInflation expectations refer to the opinion on the future inflation rate from different sections of the society, such as investors, bankers, central banks, workers, and business owners. As a result, they take this rate into account when making decisions about various economic activities they want to engage in in the future.read more 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.

Sacrifice Ratio Formula

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.

Calculation Example

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.