When policymakers aim to control high inflation, they often face the challenge of making economic sacrifices, which can be understood through the concept of the sacrifice ratio. This ratio quantifies the percentage of GDP lost to reduce inflation by 1%. For instance, if a 3% decrease in GDP results in a 1% reduction in inflation, the sacrifice ratio would be 3.

Inflation expectations play a crucial role in determining the position of the short-run Phillips curve, which illustrates the inverse relationship between inflation and unemployment. An increase in expected inflation shifts the short-run Phillips curve to the right, while a decrease shifts it to the left. This shift has broader implications, affecting nominal and real interest rates. The nominal interest rate is the stated rate on a loan, while the real interest rate is adjusted for inflation. For example, if a bank desires a real interest rate of 5% and anticipates 2% inflation, the nominal rate charged would be 7% (5% + 2%). If expected inflation rises to 4%, the nominal rate would increase to 9% to maintain the same real return.

To combat inflation, the Federal Reserve may implement contractionary fiscal policy, which involves selling Treasury bills to decrease the money supply. This action raises equilibrium interest rates, leading to reduced investment and lower aggregate demand. Consequently, this results in a lower price level and GDP, illustrating the trade-off between inflation control and economic growth. As GDP decreases, unemployment tends to rise, reinforcing the relationship depicted by the Phillips curve.

In the short run, contractionary policy moves the economy down the Phillips curve, resulting in lower inflation but higher unemployment. For example, if inflation decreases from 8% to 4%, unemployment may rise from 3% to 7%. Over time, as inflation expectations adjust downward, the short-run Phillips curve shifts left, leading to a new long-run equilibrium with lower inflation and a return to the natural rate of unemployment.

Ultimately, the sacrifice made in the short run—characterized by reduced GDP and increased unemployment—is necessary to address high inflation. In the long run, as expectations align with the new economic conditions, the economy can stabilize at a lower inflation rate while returning to the natural rate of unemployment.

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