Chapter 13 – Buffer Stocks and Price Stability<\/strong><\/p>\n [Continuing from Part 1]<\/p>\n 13.2 Measuring the costs of unemployment buffer stocks<\/strong><\/p>\n Under inflation targetting monetary policy regimes, central bankers use the persistent pool of unemployed (and other forms of labour underutilisation, for example, underemployment) as a buffer stock to achieve a desirable price level outcome. If their inflation outlook rises above their target rate they will induce higher rates of unemployment by increasing in interest rates until they are satified their inflation target is being met.<\/p>\n While some extreme elements of the profession, who still consider rational expectations to be a reasonable assumption, will deny any real output effects, most economists acknowledge that any disinflation engendered by this approach will be accompanied by a period of reduced output and increased unemployment (and related social costs) because a period of (temporary) slack is required to break inflationary expectations.<\/p>\n The real question then is how large are the output losses following discretionary disinflation? There is overwhelming evidence to suggest that the cumulative costs of this strategy in real terms have been substantial.<\/p>\n Economists measure these real costs in terms of sacrifice ratios<\/strong>, which is the accumulated loss of output during a defined disinflation episode as a percentage of initial output expressed as ratio of the accumulated reduction in the inflation rate.<\/p>\n For example, if the sacrifice ratio was two it would mean that a one-point reduction in the trend inflation rate is associated with a GDP loss equivalent to 2 per cent of initial output.<\/p>\n Figure 13.1 is a simple graphical depiction of the sacrifice ratio concept and captures the way most empirical studies have pursued the estimation of sacrifice ratios.<\/p>\n The cumulative output loss as a consequence of the actual output falling below potential output is depicted by the shaded area. In Figure 13.1, we have deliberately constructed output to resume at its potential level at the exact end of the disinflation period (defined as the period between the peak inflation and the trough inflation). This is the normal assumption adopted in empirical studies.<\/p>\n Figure 13.1 Sacrifice ratios and disinflation episodes<\/strong> The depiction in Figure 13.1 assumes that the disinflation episode has a relatively finite, short-term impact on real GDP growth and before long the actual growth path converges on the potential path (which was unchanged by the policy change).<\/p>\n However, in the real world, it is clear that a prolonged period of reduced real GDP growth lasts beyond the formal disinflation period and that the potential real GDP growth path also declines as the collateral damage of low confidence among firms curtails investment (which slows down the growth in productive capacity).<\/p>\n As a consequence, the estimates of sacrifice ratios, based on the conception shown in Figure 13.1, will be biased downwards because they ignore the impacts of output persistence and hysteresis.<\/p>\n The concept of persistence<\/strong> means that actual output remains below its potential after the disinflation period has finished. The longer this output gap exists, the longer is the persistence.<\/p>\n Relatedly, hysteresis<\/strong> (in this context) refers to the permanent losses of potential output that arise as a consequence of the disinflation policy.<\/p>\n The important point is that to accurately estimate the sacrifice ratio researchers must not only consider the short-term losses but also the longer-term losses arising from persistence and hysteresis.<\/p>\n Figure 13.2 stylises the impacts of persistence and hysteresis arising from a disinflationary policy stance. It is clear that the real output losses are much greater than would be estimated using the restricted concept shown in Figure 13.1.<\/p>\n From the inflation peak, real output falls immediately as before. But after a time, the reduced levels of economic activity erodes confidence among consumers and firms. Consumers fearing even higher unemployment restrict consumption spending and firms respond to the lack of sales order by cutting investment plans.<\/p>\n Two impacts occur as a result: (a) the potential real output path falls (from Trough + x quarters on Figure 13.2), reducing the growth capacity of the economy; and (b) actual real output deviates from its potential path for much longer that otherwise would have been the case.<\/p>\n As a result, the estimated costs of the disinflation are much larger. Eventually actual and potential may converge but at that point there is less output and national income and almost certainly, persistently higher unemployment.<\/p>\n Economies reach a difficult point where the mass unemployment, initially caused by the failure of aggregate demand induced by the contractionary policy stance of the government, also becomes capacity constrained as a result of the falling potential output level.<\/p>\n The fiscal austerity policies pursued by governments during the global financial crisis also have had this impact. It is much harder to then restore robust growth because it takes longer periods to also ensure there is potential capacity to support it without triggering inflation.<\/p>\n Figure 13.2 Sacrifice ratios with persistence and hysteresis<\/strong> Mitchell and Muysken (2008) drew on an extensive literature analysis and their own empirical work to conclude the following:<\/p>\n
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