Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Taking Action with Disinflation Policy


Disinflation policy refers to a policy intended to reduce inflation. Policy makers usually undertake it when the economy is experiencing persistently high inflation. As we describe in Chapter 5, high inflation is very socially costly. Furthermore, high inflation brings few, if any, benefits; certainly, it doesn’t help to reduce unemployment (as the long-run Phillips curve makes clear – see the preceding section). The big question is: is it possible to reduce inflation and inflation expectations without increasing unemployment as the Phillips curve would suggest?


Here’s how policy makers carry out disinflation policy:

1. 
   They make an announcement along these lines: ‘inflation has been far too high for far too long, so we’ve decided to reduce it’.
   

2. 
   They undertake contractionary monetary policy (see Chapter 9) by reducing the money supply (or reducing the growth rate of the money supply).
   

In this section you discover that disinflation policy can be very painful and result in a period of high unemployment and low output. But you also find out how people forming expectations about the future is crucial in determining how painful disinflation is.


Seeing the sacrifice ratio: No pain, no gain

Quite simply, disinflation is painful, because it usually involves contractionary monetary policy and so reduces aggregate demand (as we discuss in Chapter 9). The result is a recession in the short run and reduced output and increased unemployment (as the earlier Figure 12-1 shows).

The sacrifice ratio is a measure of how painful disinflation is likely to be. It measures the percentage of real output (in one year) that has to be given up in order to reduce inflation by 1 percentage point:

For example, if you had to give up 10 per cent of one year’s worth of GDP in order to reduce inflation by 2 per cent, the sacrifice ratio equals 5. Traditionally, economists thought that policy makers could choose how to spread the pain. So, for example, they could get it over and done with quickly by reducing GDP by 10 per cent this year, or spread it over a period of time by reducing GDP by 1 per cent each year for ten years, or even 2 per cent each year for five years and so on.

Given this understanding, many policy makers preferred the idea of spreading the pain over a longer period and gradually reducing inflation. We walk you through an example of that approach now, beginning with an economy as shown in Figure 12-7. Inflation (and inflation expectations) start off very high, at , and the Phillips curve is represented by SRPC₀:

1.