What is the cost of reducing inflation by a percentage point? According to the 1995 Economic Report of the President, the cost at that time was though to be a cumulative total of 2 percentage points of lost output. For example, to decrease inflation by three percentage points we must sacrifice 2 percent of GDP for three years or 1 percent of GDP for six years, or some other combination of years and loss of annual output. This relationship is formalized through the concept of the sacrifice ratio, defined as
This cost can be translated into unemployment using Okun's law. As described in chapter 3, Okun's law says that 2 percentage points of annual potential output are lost by each percentage point in unemployment above the NRU. This implies that a sacrifice ratio of 2 corresponds to a cost of 1 percentage point of annual extra unemployment required to reduce inflation by one percentage point.
The sacrifice ratio can vary across countries and over time depending on the flexibility of wage-setting systems and the credibility of central bank policies. Estimates suggest that during the late 1970s it was about 5 or 6 and that during the later during the later years of the Volcker era at the Fed it had fallen to 3 because Volcker had built up such high credibility.
This description of the sacrifice ratio suggests that the total cost in terms of lost output is the same whether the central bank adopts the ''cold turkey" approach to lowering inflation, in which there is an immediate large reduction in the rate of growth of the money supply, or the "gradualism" approach in which the rate of growth of the money supply is lowered gradually over an extended time period. Realistically, however, it would be advisable to use the cold turkey approach only if the central bank has high credibility and the nation's wage and price setting systems are quite flexible. Otherwise, inflation would not fall quickly to match the lower growth in the money supply, the demand for money would increase by much more than the supply of money, aggregate demand would then fall, and the economy would enter a severe recession.
12.4 Wage-Price Controls
A major reason why lowering inflation requires a prolonged recession is the coordination problem: people will not moderate wage and price increases until everyone else does. A wage-price control policy, such as that imposed by President Nixon in 1971, puts legal constraints on wage and price increases. Controls policies and their variants, such as wage-price guidelines with no formal legal penalties, or guidelines with a tax on excessive wage or price increases, are called incomes policies. An incomes policy imposes the missing coordination and, by doing so, allows the economy to move quickly down the long-run Phillips curve, thus avoiding the high cost of a prolonged recession. This is the benefit of a policy of wage-price controls.
