III. The Macroeconomic Model
Volcker chose to use a method of preemptive restraint, which took a toll on GDP, but was very effective at reducing the growing rate of inflation. He and his team implemented preemptive restraint creating what is called a sacrifice ratio. The sacrifice ratio is equal to dollar cost of production loss divided by the change in inflation (Sacrifice Ratio Definition, Investopedia) . Simply put this is the cost associated with slowing down an economy and reducing inflation. Roughly five percent of real GDP must be given up in order to reduce inflation by one percent (econport).
Phillips curve The Phillips curve shows the relationship between inflation and unemployment and it is closely related to the short run aggregate supply (SRAS) curve. SRAS curve demonstrates the positive relationship between price levels and real output (Y). As Price levels increases, output will increase, and unemployment will decrease.
Although, the goal of all monetary policies is to decrease unemployment and stabilize inflation, the Phillips curve shows that we cannot improve one target without making the other one worse. There must be a trade-off between the two targets. Accordingly, Volcker has used restricted monetary policy where the effects starts from real money balance …show more content…
The rise in inflation rate causes rightward shift in output level at point B resulting in an inflationary gap to the economy. This also, causes a rightward shift in the IS model. Due to the continues increases in inflation rate over the last decade and over the beginning of Volcker monetary policy implementation, it caused a left shift in the Phillips curve to PC1 as shown in figure 2. Volcker and FOMC members started implementing the monetary policy of reducing money supply or increasing interest rate to work as an instrument in reducing inflation
Volcker chose to use a method of preemptive restraint, which took a toll on GDP, but was very effective at reducing the growing rate of inflation. He and his team implemented preemptive restraint creating what is called a sacrifice ratio. The sacrifice ratio is equal to dollar cost of production loss divided by the change in inflation (Sacrifice Ratio Definition, Investopedia) . Simply put this is the cost associated with slowing down an economy and reducing inflation. Roughly five percent of real GDP must be given up in order to reduce inflation by one percent (econport).
Phillips curve The Phillips curve shows the relationship between inflation and unemployment and it is closely related to the short run aggregate supply (SRAS) curve. SRAS curve demonstrates the positive relationship between price levels and real output (Y). As Price levels increases, output will increase, and unemployment will decrease.
Although, the goal of all monetary policies is to decrease unemployment and stabilize inflation, the Phillips curve shows that we cannot improve one target without making the other one worse. There must be a trade-off between the two targets. Accordingly, Volcker has used restricted monetary policy where the effects starts from real money balance …show more content…
The rise in inflation rate causes rightward shift in output level at point B resulting in an inflationary gap to the economy. This also, causes a rightward shift in the IS model. Due to the continues increases in inflation rate over the last decade and over the beginning of Volcker monetary policy implementation, it caused a left shift in the Phillips curve to PC1 as shown in figure 2. Volcker and FOMC members started implementing the monetary policy of reducing money supply or increasing interest rate to work as an instrument in reducing inflation