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Revisiting Inflation, Unemployment, and Policy


Sacrifice Ratio

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So when policy makers are trying to control inflation as it's getting really high. Well they're gonna have to make some sacrifices. Let's see what that is in the sacrifice ratio. So expectations about inflation, remember that's going to be a definite a determinant of the position of the short run phillips curve. Right. We saw how expected inflation affects the short run phillips curve, right. It can shift right or shift left based on changes in those expectations. So if expected inflation increases, we're gonna shift to the right, we're gonna shift the short run phillips curve to the right. And if it decreases, well we're gonna shift to the left and that's based on expected inflation. So the expected inflation is going to affect uh have implications throughout the economy, Not just on our short runs Philip group, think about interest rates, how expected inflation affects interest rates were nominal interest rate and our real interest rate. Remember that the nominal rate, This is like the stated rate on the loan when you go to the bank and they say, Hey you need to pay me 10% interest. That's the nominal rate. The real rate is adjusted for inflation. Okay, they're adjusted for inflation adjusted for inflation. Um So this is basically the rate that they're actually getting after uh the prices go up in the economy. So let's see an example here. And let's see how the relationship here with real and nominal rates. So if the real interest rate of bank wants to earn is 5%, they want to earn 5% on the loan but there's inflation of 2%. Well we've learned previously this relationship. The 5% plus the 2%. They're gonna need to charge 7% as the nominal rate. So this real rate they want to earn five But there's this inflation expected of 2% so they're gonna charge you 7% so that they can still make their 5% at the end of the day. Right because of this inflation Now let's see what happens to the nominal rate um when expected inflation increases to 4%. So in this case they still want to make 5%. But if not if expected inflation is 4% they're gonna need to charge 9% on the loan right 5% plus 4%. And that's the same situation. They'll charge 9% to cover the inflation of 4% and still be left with a real interest rate of 5% so let's see this whole relationship here and what it has to do with our unemployment or inflation and our short run phillips curve. So if the Fed wants to reduce the inflation rate well they must pursue contractionary fiscal policy. Right contractionary fiscal policy. And what happens in contractionary fiscal policy, they're going to be selling treasury bills right? They sell Treasury bills so that they get money so the money supply decreases. And we talked about this in other videos when we were doing monetary policy. I'm sure you could just type contractionary monetary policy into your search bar and you'll get more information if this kind of has slipped your mind a little bit. But this is basically what contractionary monetary policy does. It lowers the money supply which increases the equilibrium interest rate. And at higher interest rates we have less investment, right? There's less investment occurs at the higher interest rates bringing aggregate demand down. And with lower aggregate demand we have a lower price level and less GDP right? Less GDP less price level. Um So this is the sacrifice. They must make right to bring down the inflation to bring down to bring down inflation the price level. They must sacrifice some G. D. P. Right? Um And that's that relationship we saw with unemployment and inflation lower GDP meant higher unemployment. So the sacrifice ratio tells us the percentage of GDP lost in the process of lowering inflation by 1%. So how much GDP do we have to give up to lower inflation by 1%. So it's the percent change in G. D. P. So let's say GDP goes down 3%. You do it in another colour. GDP goes down 3% to get a 1% change in inflation right? We lose 3% of GDP to bring down inflation by 1% or we have a sacrifice ratio of three in that case. Okay so let's see how this works on the graph. So the first thing that happens is this contractionary policy right? The contractionary policy it's not gonna shift the graph at all. What we're gonna have here notice this is our phillips curves on the graph. So we've got our inflation rate over here an unemployment rate over here. Okay And just like we went through with our contractionary fiscal monetary policy up here remember what what happened what was the result of this contractionary policy was a lower price level and lower GDP. And when I say lower GDP it means more unemployment. Right? And that's exactly what we've learned about the phillips curve. Right? So if we had started at this point we'll say this was 0.0.1 right here and then we go through some um some contractionary fiscal policy. It's gonna move us down the phillips curve are short run phillips curve because we're in a situation where we've brought down inflation right just like we saw up here contractionary fiscal policy is going to bring down the price level but we're also sacrificing some G. D. P. And we're gonna have more unemployment in that case. And that will bring us over here to some point over here .2 on the graph. OK and that's what's happening in this case right here contractionary policy moves the economy down the short run phillips curve. Okay so the the contractionary policy moves us down here to this new situation right where we have less Inflation. So let's say the inflation rate up here was 8% and we brought it down to the situation where it's 4% right, we're now at 4%, but we've got much more unemployment, so unemployment might might be now at 7% over here where it was 3% originally. Okay, so we've increased our unemployment, we've sacrificed some GDP, we've increased unemployment and then over time what's gonna happen is we're gonna have new expectations about inflation. So in the long run the expected inflation decreases. And what have we learned at the top of the page? Right, what did we learn? Uh What do we remember? At least we learned in another video when expected inflation decreases, we shift left our short run phillips curve. Right, that's the relationship of our short runs phillips curve. Uh one of the determinants being the expected inflation. So in the long run we would have a new short run phillips curve somewhere to the left. Because of these lower expected inflation, we would have short run phillips curve here, that's to the left and we would be at this new equilibrium In the long run where we've got 4% inflation and 3% unemployment. Okay, so this is the sacrifice that we must make. In the short run, we must make this sacrifice where we have less GDP and more unemployment to combat that inflation. In the long run it's gonna shift our short run Phillips curve to the left leading to a new long run equilibrium here with lower inflation. And the same unemployment again, that natural rate of unemployment. Okay, so remember, this is the natural rate of unemployment, and we get back to that in the long run. Cool. So that's the sacrifice ratio there. That's what we have to give up in the short run to combat that out of control inflation. Cool. Let's go ahead and move on to the next video.