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 policies will have on the country's output.
The sacrifice ratio is calculated by taking the cost of lost production and dividing it by the percentage change in inflation.
Breaking Down a Sacrifice Ratio
A country's historic sacrifice ratios can be used to guide policymaking by providing a snapshot of how the country might respond if the level of inflation changes by 1%. If inflation is becoming a problem in an economy, central banks have tools they can use to try to cool 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, and the sacrifice ratio measures that cost.
Example of Sacrifice Ratio
For example, the central bank of Gatlinburgia is concerned about increasing inflation. The prices of bread and beets are becoming too high for many of its residents to afford. The Gatlinburgian central bank raises interest rates and curbs their stimulus programs to cool the economy. Their efforts work, and the Gatlinburgian CPI falls 3%. However, in response to falling prices, manufacturers cut back on production by $3,000,000. The sacrifice ratio is 3,000,000/3 = 1,000,000.