Sacrifice ratios and the conduct of monetary policy in conditions of low inflation

The focus of monetary policy has shifted markedly over the past 15 years away from attempts to fine tune the economy towards the longer-run goal of attaining price stability and creating the necessary conditions for sustainable economic growth. In an attempt to minimise the costs of such a transition, central banks have become more independent and monetary policy more transparent, changes intended to increase the credibility of monetary policy and to reduce short-run sacrifice ratios. However, concerns have been expressed that an environment of price stability and independent central banks may instead lead to higher sacrifice ratios and, perhaps, even higher rates of structural unemployment, because of the increased importance of nominal and real rigidities at low rates of inflation.

The purpose of this paper is to analyse whether there are any grounds for such concerns. We do so by estimating sacrifice ratios for 19 industrialised countries, using three alternative approaches: (1) estimating aggregate supply curves; (2) estimating structural price and wage equations; and (3) comparing actual changes in inflation with changes in standard measures of output and labour market slack. The empirical evidence shows that, as the average rate of inflation for the 19 countries in our sample has fallen from 8% to 3½%, the average sacrifice ratio has increased from around 1.5 to about 2.5. Although sacrifice ratios appear to have risen in virtually all countries, the increases tend to be smallest in those that have adopted measures to deregulate labour and product markets and in countries where the central bank has adopted explicit inflation targets. However, the empirical evidence also reveals that point estimates of the sacrifice ratios for individual countries are quite sensitive to the econometric method adopted. This last result suggests that identification of the sources of higher sacrifice ratios remains elusive and thus that one should be cautious about drawing strong implications for monetary policy from these kinds of estimates.