The Macroeconomic Model: Volcker's Method Of Preemptive Depenlation

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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
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The modified Phillips curve shows the negative relationship between change in inflation rate and current unemployment …show more content…
The model is based on people forming their expectations based on past inflation; this is referred to as adaptive expectations. However, the model relates the change in the inflation rate and the gap between natural and current unemployment rate.

IS model: yt –yN =-γ (it –iN)
Where yt =current output level, yN= natural or potential output level, it= current interest rate, iN= stabilizing interest rate. The model represents the output gap in an inverse relationship to the gap of interest rate (Current interest rate and natural interest rate). IS model is used in Volcker disinflationary policy to demonstrate the recessionary gap during the implementation of policy.
PC model: πt –πt-1 =β (yt –yN)
The model represents a positive relationship between Inflation gap & output gap.
MR model: yt –yN =-η (πt –π)
The monetary policy rule model represents the inverse relationship between output gap, current inflation, and target

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