Monetary Policy in Mokania
Mokania has had inflation of 15% for many years. Mokania establishes a new central bank, the Bank of Mokania, with the hopes of reducing the inflation rate.

-Refer to Monetary Policy in Mokania.The Bank of Mokania reduced inflation to its announced goal of 5%.However its efforts made the unemployment rate rise by 10 percentage points for a year while output fell by 30 percent for a year.Which of the following is correct?
A)Initially people's inflation expectations had been higher than 5%.The sacrifice ratio was 3.
B)Initially people's inflation expectations had been higher than 5%.The sacrifice ratio was 1.
C)Initially people's inflation expectations had been lower than 5%.The sacrifice ratio was 3.
D)Initially people's inflation expectations had been lower than 5%.The sacrifice ratio was 1.

Question

Monetary Policy in Mokania
Mokania has had inflation of 15% for many years. Mokania establishes a new central bank, the Bank of Mokania, with the hopes of reducing the inflation rate.

-Refer to Monetary Policy in Mokania.The Bank of Mokania reduced inflation to its announced goal of 5%.However its efforts made the unemployment rate rise by 10 percentage points for a year while output fell by 30 percent for a year.Which of the following is correct?
A)Initially people's inflation expectations had been higher than 5%.The sacrifice ratio was 3.
B)Initially people's inflation expectations had been higher than 5%.The sacrifice ratio was 1.
C)Initially people's inflation expectations had been lower than 5%.The sacrifice ratio was 3.
D)Initially people's inflation expectations had been lower than 5%.The sacrifice ratio was 1.

Quizplus · Accepted Answer

The sacrifice ratio is the percentage of GDP that must be sacrificed to permanently reduce inflation by 1 percentage point. In this case, the Bank of Mokania reduced inflation from 15% to 5%, meaning a total reduction of 10 percentage points. The sacrifice ratio is calculated by dividing the percentage point reduction in inflation by the percentage increase in unemployment and the percentage decrease in output. In this case, the sacrifice ratio would be 10/(10 + 30) = 0.25. Therefore, initially people's inflation expectations had been higher than 5% and the sacrifice ratio was 3 (1/0.25 = 4).