Reducing Inflation

Disinflation

• Stop expansionary policies and start contractionary policies.
• This slows or completely stops the rightward shift in AD.

• Stagflation is a rare economic cycle that occurs when there is slow economic growth, high inflation, and rising unemployment.
• In the second phase, stagflation occurs as the AS curve continues to shift upward due to inflation expectations, leading to a reduction in output and rising prices.

• Scenario 1: Market adjusts itself on its own through the adjustment process, wages fall slowly, AS shifts right and the recessionary gap is closed.
• Scenario 2: Central bank starts expansionary policies again by increasing the money supply, AD shifts right and the recessionary gap is closed.

The Cost of Disinflation

• The cost of disinflation is the temporary loss of economic activity and the rise in unemployment that occurs during the process.
• The depth and duration of the recession during disinflation depend on how quickly inflation expectations adjust to policy changes.
• The sacrifice ratio represents the percentage of real GDP that is "sacrificed" for each percentage point of inflation reduction. This is the cost of disinflation.