Question

(i) Explain why a policy to reduce an inflation rate is very costly to a country?
(ii) Can the disinflation strategy be achieved without any cost to the country? Explain?

Answer 1

Answer 1

An economy can get into the recession by reducing inflation. Some inflation is always necessary to keep the economy growing. The major cost the economy entails while fighting from the inflation is output and employment. According to the Philips curve, inflation and output are inversely related to each other. If one increase other has to decrease. The GDP of the country gets sacrificed in order to reduce inflation. The output falls because the aggregate demand falls. Hence, there is an output loss. Unemployment and inflation are inversely related. If unemployment increases in the country, the aggregate demand will fall which will lead to a decrease in inflation.

Sacrifice Ratio = Loss of GDP/Percentage fall in the inflation rate

It concludes that an economy has to bear major costs in terms of output and unemployment in order to reduce inflation by implementing policies.