A BENEFIT-COST ANALYSIS OF DISINFLATION

I. INTRODUCTION In recent years, the debate on establishing price stability as the sole objective of monetary policy has intensified. Advocates of price stability argue that monetary policy has only a transitory effect on real variables such as output or unemployment. They argue that the monetary authority thus should focus on price stability to reap the benefits of a stable and predictable price path. Because the current U.S. inflation rate is positive, the Federal Reserve would have to reduce the inflation rate - disinflate, in other words - to stabilize the price level. Opponents of price stability argue that various rigidities in the economy would cause such a policy to generate a recession whose costs would exceed the benefits. One way to measure the costs of disinflation is to estimate "sacrifice ratios," the quantity of output lost for each percentage-point reduction in the inflation rate. However, sacrifice ratios are not true cost-benefit ratios: They gauge the costs of lost output, but do not assess the benefits from the lower inflation rate. This is a serious problem that causes sacrifice ratios to overstate the net costs of disinflation (see Ball, 1994; Fuhrer, 1994). Although the concept of sacrifice ratios is not new, the recent pursuit of price stability by central banks around the globe has renewed interest in, and research on, the subject. This study presents a benefit-cost analysis of disinflation and critiques of two common methods for computing these statistics. The analysis first replicates Ball's (1994) estimates of sacrifice ratios for the United States and other industrialized countries. It then extends these results by changing the methodology in several plausible ways, including estimating three alternate measures of trend output and applying two methods of timing disinflations. Ball's estimates are theoretically objectionable and are very fragile to minor changes in technique but worthy of study because of the interest they have elicited. Robert Barro (1995) calculates the benefits of disinflation and estimates the growth benefits from lower inflation (or, perhaps more accurately, the costs of inflation). Barro's estimates are better constructed from an econometric perspective than are Ball's estimates. However, the authors of the study here remain skeptical as to the validity of Barro's estimates, as well. Despite the uncertainty associated with Ball's sacrifice ratio estimates and Barro's growth estimates, relating them does permit one to obtain a rough measure of the net cost of disinflation. Findings of the analysis here indicate that, contrary to popular opinion, disinflation probably produces a net benefit, not a net cost. Additionally, the output losses associated with a typical U.S. disinflation likely are made up in 10-20 years - less than one generation. II. THE CONCEPT OF A SACRIFICE RATIO A. Stylized Time-Series Plot of Inflation and GDP - Ideal Case The sacrifice ratio is the cumulative loss of output during a disinflation episode as a percentage of initial output divided by the cumulative reduction in the inflation rate. Thus, a sacrifice ratio of three implies that a one-point reduction in the trend inflation rate is associated with a loss equivalent to 3% of initial output. The easiest way to understand sacrifice ratios is to look at a stylized picture of how GDP and inflation evolve over time, according to a simple, textbook model of the economy in which changes in money growth have real effects. Figures 1A and 1B illustrate the economy's reaction over time to a decrease in the growth rate of money. Figure 1A shows output initially growing steadily over time along the trendline, Y. Likewise, Figure lB shows that the inflation rate is at [[Pi].sub.0] until time [t.sub.0], when the monetary authority slows money growth to reduce the inflation rate to [[Pi].sub.1]. If the slowdown in money growth causes a recession, then output would fall below its trendline. …