Expectations and the cost of lower inflation
Supply shocks, the sacrifice ratio, rational expectations and the Volcker disinflation: why bringing inflation down usually costs output.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Explain how a supply shock shifts the Phillips curve
- Calculate the cost of disinflation with the sacrifice ratio
- Explain how rational expectations could lower that cost, and what the Volcker disinflation showed
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The economy behind your investments: lesson 10 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 22
What it is
Supply shocks. A supply shock directly changes firms' costs and prices, shifting aggregate supply and so the Phillips curve. Mankiw's example: in 1974, OPEC restricted oil output, and within a few years the world oil price almost doubled. Aggregate supply fell, giving both higher inflation and higher unemployment: the short-run Phillips curve shifted to a worse position. Policymakers then face a hard choice: fight unemployment by raising demand (accommodating the shock, at the cost of more inflation) or fight inflation by holding demand back (at the cost of more unemployment). The US accommodated, and Mankiw notes the problem was compounded in 1979 when OPEC raised oil prices again.
Disinflation is a fall in the rate of inflation. It is not deflation, a fall in the price level. (Mankiw's analogy: disinflation is slowing down; deflation is going into reverse.)
The cost of disinflation. To lower inflation, the central bank slows money growth, which cuts aggregate demand. In the short run the economy moves down the Phillips curve to lower inflation and higher unemployment. As people come to expect lower inflation, the short-run curve shifts down and unemployment returns to its natural rate. The temporary rise in unemployment is the cost.
The sacrifice ratio is the percentage points of a year's output lost for each percentage point that inflation is reduced. Mankiw gives a typical estimate of 5.
Quick check
Tap an answer to check it.
Inflation falls from 8% to 6%. Is this disinflation or deflation?
- Deflation means the price level itself falls
Show answer
Disinflation: prices are still rising, just more slowly. The rate of inflation fell, but it is still positive.
Why it matters
Rational expectations. In the 1970s, economists including Robert Lucas, Thomas Sargent and Robert Barro argued that people use all available information, including what they know about government policy, when forming expectations. If a central bank made a credible promise to cut inflation, expected inflation might fall quickly, so the short-run curve would shift down at once, and the sacrifice ratio could be much smaller than traditional estimates.
The Volcker disinflation. When Paul Volcker became chairman of the Federal Reserve in 1979, inflation was running at almost 10% a year. With a sacrifice ratio of 5, cutting it to, say, 4% (6 points) would cost about 30% of a year's output. Volcker tightened monetary policy. Inflation did come down, but the economy went through the deepest recession since the 1930s, with unemployment around 10% in 1982 and 1983. Mankiw notes that estimates of the sacrifice ratio from this period were smaller than earlier ones. He adds that much of the public did not believe Volcker's announcement at first, so expected inflation fell slowly: the episode doesn't refute the rational-expectations view, but shows policymakers can't count on being believed at once.
The Greenspan era. After Alan Greenspan succeeded Volcker in 1987, inflation and unemployment were relatively stable for many years, helped by favourable supply shocks and careful policy. Mankiw also shows how the 2008–2009 financial crisis cut aggregate demand, raising unemployment and pushing inflation very low.
Worked example
A country's inflation is 9%, and the central bank wants 3%. The sacrifice ratio is 5.
- Inflation cut: 9 − 3 = 6 points.
- Output lost: 6 × 5 = 30% of a year's output.
- Spread over 3 years: about 10% of output a year below normal.
- If a credible policy halved the sacrifice ratio to 2.5: the loss would be 6 × 2.5 = 15% of a year's output.
Common mistake
Thinking a central bank can cut inflation painlessly whenever it chooses. The traditional view is that disinflation costs output while expectations adjust. Rational expectations suggests credibility can reduce the cost, not that it disappears.
Key terms
- supply shock
- an event that directly changes firms' costs and prices, shifting aggregate supply and the Phillips curve
- disinflation
- a fall in the rate of inflation
- deflation
- a fall in the price level
- sacrifice ratio
- percentage points of annual output lost for each 1-point fall in inflation
- rational expectations
- the theory that people optimally use all the information they have, including about policy, when forecasting
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| supply shock | an event that directly changes firms' costs and prices, shifting aggregate supply and the Phillips curve |
| disinflation | a fall in the rate of inflation |
| deflation | a fall in the price level |
| sacrifice ratio | percentage points of annual output lost for each 1-point fall in inflation |
| rational expectations | the theory that people optimally use all the information they have, including about policy, when forecasting |
Practice
Work it through
Inflation is 12% and the target is 4%. The sacrifice ratio is 3.
- 12 − 4
- 8 × 3
- 24 ÷ 4
Quick quiz
Tap an answer to check it.
An oil-price shock hits. What happens in the short run?
- That is a movement along the curve from higher demand
Show answer
Inflation and unemployment both rise. A fall in aggregate supply shifts the Phillips curve to a worse position.
How could rational expectations lower the cost of disinflation?
- The mechanism is through expected inflation
Show answer
A credible policy could cut expected inflation quickly, shifting the short-run curve down at once. If expectations adjust fast, little extra unemployment is needed.
In Mankiw's account, roughly what inflation did Volcker face in 1979?
- Inflation was far higher
Show answer
Almost 10% a year. Reaching 4% meant cutting 6 points.
In short
- Supply shocks shift the Phillips curve, raising both inflation and unemployment.
- Disinflation (slower inflation) is not deflation (falling prices).
- Sacrifice ratio: a typical estimate is 5% of output per point of inflation.
- Rational expectations: credibility can lower the cost; the Volcker disinflation still brought a deep recession.
Mastery check
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Check yourself
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What is the sacrifice ratio?
Show answer
The percentage points of a year's output lost for each 1-point reduction in inflation.
Name two economists associated with rational expectations.
Show answer
Any two of Robert Lucas, Thomas Sargent and Robert Barro.
With a sacrifice ratio of 5, what would cutting inflation from 10% to 4% cost?
Show answer
About 30% of a year's output.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 22.
- On this site: The Phillips curve and The costs of inflation.
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