Contracts, Credibility, and Disinflation
Estimates of the cost of disinflation made before the recent reduction in the inflation rate varied widely. Estimates were made in terms of the sacrifice ratio -- the percentage points of GNP at an annual rate lost per percentage point reduction in the inflation rate. At one extreme it was argued thata resolute and credible monetary policy could reduce inflation virtually costlessly. At the other extreme were estimates that the sacrifice ratio exceeded 10. Costless immediate disinflation is not possible in an economy with long-term labor contracts. This paper sets out a simple contracting model of wage and output determination and uses it to calculate sacrifice ratios for a disinflation program, under the assumption that announced policy changes are immediately believed. Under this assumption disinflation with a structure of labor contracts like those of the United States would be less costly than typically estimated.The model is then modified to allow for the slow adjustment of expectations of policy to actual policy; sacrifice ratios then approach the ranges typically estimated. The sacrifice ratio for the current disinflation is calculated in the last section: the current disinflation was somewhat more rapid and less costly than previous estimates suggested. The calculated sacrifice ratio is consistent with the predictions of the simple contracting model.
|Date of creation:||Apr 1984|
|Publication status:||published as Fischer, Stanley. "Contracts, Credibility and Disinflation." Inflation and Unemployment: Theory, Experience and Policy Making, edited by Victor Argyand John Nevile, pp. 39-59. London: George Allen & Unwin, Ltd., 1985|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
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- Taylor, John B, 1980.
"Aggregate Dynamics and Staggered Contracts,"
Journal of Political Economy,
University of Chicago Press, vol. 88(1), pages 1-23, February.
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