How large is the output cost of disinflation?

Abstract

This paper examines estimates of, and drivers for, the sacrifice ratio, defined as the cumulative sum of foregone annualised output accruing from a disinflation of one percentage point. Three approaches are employed. The first reviews the literature on what sacrifice ratio might be expected. The second studies a generic disinflation experiment using 40 estimated macro models of the U.S. economy, calculating a distribution of sacrifice ratios. Those sacrifice ratios are high by historical standards and the paper discusses some stories for why this is so. The role of expectations formation and the credibility of policy is emphasised. The third approach investigates more closely some drivers of the output cost of disinflation by carrying out a selection of disinflation experiments using the FRB/US model, varying certain characteristics of the model's expectations formation mechanism. Pinning down a precise measure for the output cost of disinflation is challenging. However, the literature and policy experiments do offer some guidance on how the sacrifice ratio can be reduced.