Sacrifice Ratio

Reducing inflation beyond threshold point would necessitate a reduction in output in economy. How? Output in economics is the “quantity of goods or services” produced in a given time period. There are three basic sources for economic growth i.e. increases in labour, increase in capital and increase in efficiency of the factors of production. Just like increases in inputs of factors of production can cause output to go up, just like that, anything that causes labour, capital or efficiency to go down will cause a decline in output or at least a decline in its rate of growth.

When the inflation is lower than the threshhold, it brings down the cost of the factors of the production and that is why it would let the output go down. In economic terms, the loss of output is called sacrifice ratio. This sacrifice ratio varies from country to country. In India, sacrifice ratio turns out to be almost 2 over the period 1975-2000. This sacrifice ratio of 2 implies that a reduction in the inflation rate by 1 percentage point would require a reduction in output by 2 percentage points from its potential level. This means that statistically, if the inflation rate were to reduce from the current level of 7.18% (December 2012) to the acceptable 5% level, output would actually witness a de-growth from the current level of 5.3% (GDPQ2 estimates for 2012-13).