What Is the Sacrifice Ratio?
The sacrifice ratio is an economic ratio that measures the effect of rising and falling inflation on a country's total production and output. Costs are associated with the slowing of economic output in response to a drop in inflation. When prices fall, companies are less incentivized to produce goods and may cut back on production. The ratio measures the loss in output per each 1% change in inflation. By examining a country's historic sacrifice ratios through time, a governing body can predict what effect their fiscal policies will have on the country's output.
- The sacrifice ratio is an economic measure of the effect of inflation on a country's total production and output.
- The sacrifice ratio can be considered the cost of fighting inflation.
- Analysis of historic sacrifice ratios over time for an economy can indicate what effect a particular policy will have on a country's output.
Understanding the Sacrifice Ratio
A country's historic sacrifice ratios can be used to guide policymaking. An analysis of the ratio would show how the country might respond if the level of inflation changes by 1%. A higher level of inflation is often caused by strong economic growth. For example, if aggregate demand expands faster than aggregate supply in an economy, the result is higher inflation. If an economy is facing inflation, central banks have tools they can use to slow economic growth in a bid to reduce inflationary pressures.
Raising interest rates to curb spending and increase the savings rate is one of these tools. However, the potential reduction in output in response to falling prices may help the economy in the short term to reduce inflation also, and the sacrifice ratio measures that cost. The sacrifice ratio is calculated by taking the cost of lost production and dividing it by the percentage change in inflation.
Sacrifice Ratio = Dollar Cost of Production Losses/Percentage Change in Inflation
Example of Sacrifice Ratio
The inflation rate in an economy has decreased from 10 to 5% over three years at the cost of output 11%, 9%, and 5% for each year, giving a total loss of 25%.
Total loss of GDP = 25% (11 + 9 + 5)%
Decrease in Inflation Rate = 5% (10 – 5)%
Sacrifice Ratio = 25/5 = 5
That gives a ratio of 5:1.
The Sacrifice Ratio and Fiscal Policy
Disinflations, or a temporary slowing of prices, are major causes of recessions in modern economies. In the United States, for example, recessions occurred in the early 1970s, mid-1970s, and early 1980s. Each of these downturns occurred at the same time as falling inflation as a result of tight monetary policy. Thus, to avoid a recession, the government wants to find the least expensive way to reduce inflation.
The sacrifice ratio shows how much output is lost when inflation goes down by 1%. This helps central banks to set their monetary policies, depending on whether they want to boost or slow down the economy. For example, if inflation is getting too high, the central bank can use the sacrifice ratio to determine what actions to take and at what level to influence output in the economy at the least cost.