So when policymakers are trying to control inflation as it's getting really high, they're going to have to make some sacrifices. Let's see what that is in the sacrifice ratio. Expectations about inflation, remember, that's going to be a definite determinant of the position of the short run Phillips curve, right? We saw how expected inflation affects the short run Phillips curve. It can shift right or shift left based on changes in those expectations. So if expected inflation increases, we're going to shift to the right. And if it decreases, we're going to shift to the left, based on expected inflation. So the expected inflation is going to have implications throughout the economy, not just on our Short Run Phillips curve. Think about interest rates, how expected inflation affects interest rates. Our nominal interest rate and our real interest rate. Remember that the nominal rate is the stated rate on the loan. When you go to the bank and they say, "Hey, you need to pay me 10% interest." That's the nominal rate. The real rate is adjusted for inflation. So this is basically the rate that they're actually getting after the prices go up in the economy.
Let's see an example here and let's see how the relationship here with real and nominal rates is. So if the real interest rate a bank wants to earn is 5%, they want to earn 5% on the loan. But there's inflation of 2%. We've learned previously this relationship. The 5% plus the 2%, they're going to need to charge 7% as the nominal rate. So this real rate, they want to earn 5%, but there's this inflation expected of 2%. So they're going to charge you 7% so that they can still make their 5% at the end of the day, right? Because of this inflation. Now, let's see what happens to the nominal rate when expected inflation increases to 4%. In this case, they still want to make 5%, but if expected inflation is 4%, they're going to need to charge 9% on the loan. That's 5% plus 4%. And that's the same situation, they'll charge 9% to cover the inflation of 4% and still be left with a real interest rate of 5%.
So let's see this whole relationship here and what it has to do with our unemployment, our inflation, and our short run Phillips curve. If the Federal Reserve wants to reduce the inflation rate, they must pursue contractionary fiscal policy, right? Contractionary fiscal policy and what happens in contractionary fiscal policy? They're going to be selling Treasury bills, they sell Treasury bills so that they get money, so the money supply decreases, and we talked about this in other videos when we were doing monetary policy. I'm sure you could just type contractionary monetary policy into your search bar and you'll get more information if this has slipped your mind a little bit. But this is basically what contractionary monetary policy does. It lowers the money supply which increases the equilibrium interest rate and at higher interest rates, we have less investment, right? Less investment occurs at the higher interest rates, bringing aggregate demand down. And with lower aggregate demand, we have a lower price level and less GDP, right? Less GDP, less price level. So this is the sacrifice they must make, right? To bring down inflation, to bring down the price level, they must sacrifice some GDP, right? And that's that relationship we saw with unemployment and inflation. Lower GDP meant higher unemployment. So the sacrifice ratio tells us the percentage of GDP lost in the process of lowering inflation by 1%. How much GDP do we have to give up to lower inflation by 1%? So it's the percent change in GDP. So let's say GDP goes down 3% to get a 1% change in inflation, we lose 3% of GDP to bring down inflation by 1%. So we have a sacrifice ratio of 3 in that case.
So let's see how this works on the graph. The first thing that happens is this contractionary policy. The contractionary policy, it's not going to shift the graph at all. Notice this is our Phillips curves on the graph. So we've got our inflation rate over here and unemployment rate over here. Remember what happened? What was the result of this contractionary policy? It was a lower price level and lower GDP. And when I say lower GDP, it means more unemployment, right? And that's exactly what we've learned about the Phillips Curve. So if we had started at this point, we'll say this was 0.1 right here, and then we go through some contractionary fiscal policy, it's going to move us down the Phillips curve, our short run Phillips curve because we're in a situation where we've brought down inflation. Contractionary fiscal policy is going to bring down the price level, but we're also sacrificing some GDP and we're going to have more unemployment in that case. And that'll bring us over here to some point over here, 0.2 on the graph. And that's what's happening in this case right here. Contractionary policy moves the economy down the short run Phillips curve. So the contractionary policy moves us down here to this new situation, where we have less inflation. So let's say the inflation rate up here was 8% and we brought it down to this situation where it's 4%. We're now at 4%, but we've got much more unemployment. So unemployment might be now at 7% over here where it was 3% originally. So we've increased our unemployment, we've sacrificed some GDP, we've increased unemployment, and then over time, what's going to happen is we're going to have new expectations about inflation. So in the long run, the expected inflation decreases. And what have we learned at the top of the page, right? What did we learn what do we remember? At least we learned in another video. When expected inflation decreases, we shift left our short run Phillips curve, right? That's the relationship of our short run's Phillips curve. One of the determinants being the expected inflation. So in the long run, we would have a new short run Phillips curve somewhere to the left because of these lower expected inflation. We would have a short run Phillips curve here, that's to the left, and we would be at this new equilibrium in the long run where we've got 4% inflation and 3% unemployment. So this is the sacrifice that we must make in the short run. We must make this sacrifice where we have less GDP and more unemployment to combat that inflation. In the long run, it's going to shift our short run Phillips curve to the left, leading to a new long run equilibrium here with lower inflation and the same unemployment again, that natural rate of unemployment. Cool? So that's the sacrifice ratio there. That's what we have to give up in the short run to combat that out of control inflation. Cool. Let's go ahead and move on to the next video.
