Cost of Disinflation

Economics 2B May 2014

4. Suppose the economy has been operating with an inflation rate of 10% for a long time. Suppose the central bank makes an announcement that they start targeting 5% inflation rate. What will be the cost of such disinflation? Can disinflation be costless?

The Philips curve shows that in the absence of a beneficial supply shock, lowering inflation requires a period of high unemployment and reduced output. To explain this we can use the sacrifice ratio and Okun’s law. To reduce inflation, policymakers can contract aggregate demand causing unemployment to rise above the natural rate. The sacrifice ratio measures the percentage of a years real GDP that must be forgone to reduce inflation by 1 percentage point. Estimates vary, but typically it lies between 3 and 5. So in reducing the inflation rate from 10% to 5%, taking the sacrifice level to be 3 in this example, requires a loss of 5x3=15% of one year’s GDP. This could be achieved in several ways e.g. reduce the GDP by 15% for one year or 7.5% for two years etc. thus, the cost of disinflation is the loss of GDP. One can then use Okun’s Law to translate this cost into unemployment. Okun’s Law states that each 1 percentage point of unemployment implies lost output of 2 percentage points. So the 15% loss of a year’s GDP translates to a 7.5% cyclical unemployment. Therefore, cutting inflation to 5% when everyone expects it to be 10% will cause a recession with unemployment rising (to U’ in graph below) GRAPH. If everyone anticipated the fall in inflation, so that the actual and expected inflation simultaneously fell to 5% then there would be no rise in unemployment. The cost of reducing inflation comes from the cost of changing people’s expectation. If expectations can be changed without cost, inflation can be reduced without cost. Thus, if government can lower expected inflation to the desired level of inflation, then there is no need for unemployment to rise above natural rate. According to the...