Home > Macro, Monetary Policy > Disinflating the economy 1 – the labour market

Disinflating the economy 1 – the labour market

Getting inflation out of the economy is not an easy task, which is why it is always preferable to prevent inflation getting too high in the first place. When higher inflation gets into the system, eventually the economy will return to a medium run equilibrium in terms of output and unemployment, and inflation will stabilise at a constant, but high level. Inflation stabilises because when the economy is at the natural rate of unemployment, the change in inflation from one year to the next is 0.

Removing inflation usually involves either tightening up the labour market or changing inflationary expectations. Here I will deal with disinflation through tightening the labour market – which is painful as it involves accepting higher unemployment. In 1991 the UK Chancellor Norman Lamont said that “rising unemployment and the recession have been the price that we have had to pay to get inflation down, that price is well worth paying”. This comment has got widespread notoriety and you often hear journalists trying to promote a similar response by asking politicians if they think unemployment is a price worth paying. The basic principle that Lamont was referring to was that if you accept temporarily higher unemployment, you can get inflation out of a system, and then when the economy restabilises at the natural rate of unemployment, inflation will stabilise again at a lower rate.

This common form of the Phillips Curve \pi_t - \pi_{t-1} = -\alpha (u_t - u_n) implies that disinflation can only be obtained at the cost of higher unemployment, however the total amount of unemployment required for a given decrease in inflation does not depend on the speed at which disinflation is achieved – the total amount of higher unemployment can either be spread over a short or longer period of time.

The sacrifice ratio is the number of point-years of excess unemployment needed to achieve a decrease in inflation of 1%. If we consider what would cause inflation to fall by 1% in terms of the Phillips Curve we get -0.01 = -\alpha (u_t - u_n) \Rightarrow \frac{0.01}{\alpha}=u_t - u_n. In other words the total amount of excess unemployment (above the natural rate) required for one year, to reduce inflation by 1%, would be \frac{0.01}{\alpha}. This ratio does not depend on policy. The total amount of excess unemployment is defined in ‘point years’ so you could disinflate the economy by 1% over 3 years by having an excess level of unemployment of \frac{0.01}{3\alpha} per year.

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Categories: Macro, Monetary Policy
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