1) The sacrifice ratio refers to the cost of outputs that result from a reduction of the inflation rate by one percentage point over a given period. One way of reducing inflation is through stringent monetary policies that lower the inflation rate by one percent over a given period. The sacrifice ratio is determined by the total gaps in outputs (differences between potential and actual outputs), which is given as a percentage Gross Domestic Product (GDP). The total output cost is equivalent to the GDP lost over a particular period.
Sacrifice ratio is usually used to determine the effects of real monetary policies. It is an important concept in the empirical and theoretical analysis of economic situations in a country, by expressing it in a single unit of cost measure. The computation of the sacrifice ratio entails two steps; identification of changes in monetary policy (to determine the differences between disinflation and inflation episodes) and assessing their effects on inflation and output gaps. There are many methods for estimating the sacrifice ratio.
One of the ways of computing sacrifice ratio is the “Philips curve” method that takes into account episodes of inflation and output costs within a given period. According to this method, the United States has a sacrifice ratio of 10%, which means that a decrease in inflation by one percentage point will result in a 10% decline in Gross Domestic Product (GNP). However, this approach has some limitations: the inflation-output relation is assumed to be a constant during the entire period of the analysis i.e. it remains constant during periods of accelerating inflation and disinflation. The Philips curve method also assumes that the output cost of tackling inflation remains the same in all disinflation episodes during the entire period being examined. The computation of the sacrifice ratio involves identifying specific disinflation episodes, which are located on the peaks and dips of the inflation graph. The sacrifice ratio for the disinflation episodes is computed from the total output costs in a given duration.
2) The sacrifice ratios often vary from one country to another. This can be attributed to a variation in economic conditions. Fluctuations in oil prices may cause rapid disinflation, which will affect the inflation rates and subsequently the sacrifice ratio. The reduction in the sacrifice ratio may be related to citizen’s inflation expectations and the decline in central bank credibility. These two factors determine the output costs required to reduce the high inflation. For instance, in the 1980s, the central banks of most European countries faced a low credibility resulting in disinflation. This slowed the efforts of fighting high inflation. Also, these actions increased the inflation rate forcing governments to adopt disinflation policies resulting in high output costs. Thus, the credibility of central banks and a country’s expectation of inflation, especially when fighting inflation can affect the cost of disinflation. A country’s sacrifice ratio decreases when the disinflation costs are low and increases when the disinflation costs rise.