Sacrifice ratio and cost of inflation for the Indian economy

Abstract

Traditional concept of the Sacrifice Ratio measures the loss of potential output sustained by the society in the medium term to achieve reduction in the long-run inflation by one percentage point. This concept is critically examined and generalized to include episodes increasing the long-run inflation rate to gain higher growth of output and employment and hence reduction in the poverty proportion in the medium term. Since the concept needs measurement through a shifting short-run equilibrium of dynamic aggregate demand and supply in terms of inflation rate and output attributable to monetary policy interventions, its estimation is challenging. There are two alternative approaches to estimate the ratio, the direct one and regression based. Both have their relative merits and demerits. The regression based approach provides one unique average estimate of the Sacrifice Ratio for all episodes but allows holding other factors constant. The direct approach provides separate estimates by episodes but fails to hold other factors constant. The Sacrifice Ratio turns out to be in a narrow range of 1.8 to 2.1 for deliberate deflation and 2.8 for inflation in India. On the other hand, benefits of one percentage point reduction in trend rate of inflation are at best 0.5 percentage points increase in long-term growth of output that occurs after 4-5 years. This has implications on policy to disinflate.