Supply Shocks and Sacrifice Ratio

Supply Shocks and Sacrifice Ratio

• Supply Shock - an event that directly alters firms’ costs and prices, shifting the economy's aggregate-supply curve and thus the Phillips curve. Example: increase in the world price of oil would be a

  negative

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  supply shock.

• Sacrifice Ratio - the number of percentage points of one year’s output lost in the process of reducing inflation by 1 percentage point. Example: if the inflation falls by 2% and the output falls by 6% then the sacrifice ratio is

  3

  ---

  .

• Okun’s Law - the number of percentage points the unemployment rate increases when GDP falls by 1 percentage point. It's normally around 0.5 so this means if GDP falls by 1% the unemployment will increase by

  0.5%

  ---

• Rational expectations - the theory according to which people optimally use all the information they have, including information about government policies, when forecasting the future. If people react quickly to government policy of reducing inflation then people would lower their expected inflation and the sacrifice ratio will be

  smaller

  ---

• Zero Inflation Target - this means a target inflation of 1% (which is called zero inflation) by the central bank. It is difficult to achieve because people can still have higher expected inflation.