What is Sacrifice Ratio? Explain with Diagram.

What is Sacrifice Ratio? Explain with Diagram.

Any attempt to reduce inflation leads to recession. In accountancy  it is defined differently. When there is a change in the profit sharing ratio due to any of the reason, one or more of the existing partners have to surrender some of their old share in favour of one or more of other partners. That surrender of profit in ratio is called sacrificing ratio. Or Sacrifice Ratio is the ratio of cumulative percentage loss of GDP (due to disinflationary policy) to the reduction in inflation that is actually achieved.

It is calculated as below:

The sacrifice ratio is calculated by taking the cost of lost production and dividing it by the percentage change in inflation.

 Sacrifice Ratio=  Rupee cost of Production Loss/ Percentage change in Inflation

Or Sacrifice Ratio = Loss of level of output/Every percentage fall in rate of inflation

Due to inflation, aggregate demand (AD) falls and therefore output falls. There is loss of output.

For Example:

Inflation rate is decreased from 12%  to 5% over 3 years at the cost of output 15%, 12% and 8% below the potential output (full employment) in first, second and third year, respectively.

Total loss of GDP = 35% (15 + 12 + 8)%

Decrease in Inflation Rate = 7% (12 – 5)%

Sacrifice Ratio = 35/7 = 5 that is 5:1. It implies for every 1% of decrease in inflation rate 5% of GDP has to be scarified.Thus, the sacrifice ratio is the cost of fighting inflation, or the cost of disinflation.

According to the Phillips curve:

When prices fall, companies are less incentivized to produce goods and may cut back on production. The ratio measures the loss in output per each 1% change in inflation.
There exists a trade-off between output and inflation. The short run Phillips curve is quite flat. Within a year, one point of extra unemployment reduces inflation by about 0.5 point, holding inflation expectations constant. In other words, 1-point reduction in inflation costs 2-points of unemployment.

According to Okun’s law:  2 point of unemployment costs 4 per cent of output, that is, loss of output worth 4% .  According to Okun, the sacrifice ratio is 4.  Different economists have different opinion some say during disinflation, expected inflation falls this will drop the sacrifice ratio. Thus, we find that the sacrifice ratio varies depending on the time, place and methods used to reduce inflation.

To reduce the inflation rate, the Central Bank of a country has to pursue contractionary Monetary Policy or tight money policy.  Figure shows some of the effects of such a decision. When the Central Bank slows the rate at which the money supply is growing, it contracts aggregate demand. The fall in aggregate demand, in turn, reduces the quantity of goods and services that firms produce, and this fall in production leads to a rise in unemployment. The economy begins at point A in the figure and moves along the short-run Phillips curve to point B, which has lower inflation and higher unemployment. Over time, as people come to understand that prices are rising more slowly, expected inflation falls, and the short-run Phillips curve shifts downward. The economy moves  to point C. Inflation is lower than it was initially at point A, and unemployment is back at its natural rate.

 

Figure  Dis-inflationary Monetary Policy in the Short Run and Long Run

If the Central Bank pursues contractionary monetary policy to reduce inflation the economy moves along a short run Phillips curve from point A to point B. Over time, expected inflation falls, and the short-run Phillips CUM.’ shifts downward. When the economy reaches point C, unemployment is back at its natural rate. Thus if a nation wants to reduce inflation it must endure a period of high unemployment rate.

Disinflation/Reduction in inflation can be less costly when:

1. The Central Bank follows the policy rule and announces inflation/ disinflation in advance.

2. Deceleration or fall in output is is gradual

3. Bank Policy of disinflation is credible and people believe in the announced policy.

4. Importance of expected inflation (π^e) is more in determining current inflation (π)

5. Response of price and wages to demand conditions are very high

 (In Accountancy) SACRIFICING RATIO

Sacrificing Ratio = Old Ratio – New Ratio

The main purpose of calculating this is to determine the amount of compensation to be paid by the Gaining partner to the sacrificing partner (usually paid on the basis of proportionate amount of Goodwill).

GAINING RATIO

When profit sharing ratio changes among the partners, then one or more existing partners gain some portion of other partners’ share of profit. This ratio of gain of profit is known as gaining ratio. It can be calculated as follows:

Gaining Ratio = New Ratio – Old Ratio

Example:  A  and B are partners in a firm sharing profits in the ratio of 5:3. With effect from 1^st April, 2018 they agreed to share profits equally. Calculate the individual partner’s gain or sacrifice due to change in ratio.

Solution:

Old Ratio of A and B = 5:3

New Ratio of A and B = 1: 1

Sacrifice or Gain:

A = 5 / 8 – 1 / 2 = 10 – 8 / 16 = 2 / 16 = 1 / 8 (Sacrifice)

B = 3 / 8 – 1 / 2 = 6 – 8 / 16 = 2 /16 = 1 / 8 (Gain)

A has sacrificed 1 / 8^th share whereas B has gained 1 / 8^th share.

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Distinguish between internal and External Balance.

Various countries face policy dilemma in terms of their internal and external balance. The internal balance refers to output at full employment level whereas the external balance refers to balance of payments equal to zero.

The balance of payment is equal to 0 due to the assumption of perfect capital mobility. This dilemma sometimes happens due to clashes between the internal and external balance goals of the country.

The vertical line mm’ shows the amount of imports that in the short-run gives external balance. The two aims (internal and external balance) of the economy are jointly and simultaneously fulfilled at the point P in the Fig. 51.1 where the two lines intersect. Corresponding to these two aims are the two policy measures—monetary plus fiscal policy, on the one hand, and variations in the exchange rate, on the other.

If an economy is at the point where there is under-employment and deficit in balance of payments then an expansionary monetary policy would result into policy dilemma since the policy will help in increasing employment but at the same time would worsen the balance of payment deficit. This is because expansionary monetary policy shifts LM curve downwards resulting into an increase in income but a decline in the rate of interest. Thus, the policy even though would help in maintaining the internal balance but would not achieve the external balance.

However, an expansionary fiscal policy shifts IS curve upwards resulting into increase in both the output and the rate of interest thus moving the economy more towards the point E. Therefore, depending upon where the economy is in the four quadrants of figure , a mix of both monetary and fiscal policies would be required to achieve both internal and external balance of the economy but that would again depend upon the regime of exchange rate prevailing in the economy.

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Distinguish between (i)Clean and Dirty Exchange Rates (ii) Depreciation and Devaluation

                  Clean and Dirty Exchange Rate

Whenever the Central bank of the country do not intervene in the foreign exchange markets, in other words do not buy or sell currencies in the market, and allow the exchange rate to be determined freely by the market forces of demand and supply in the economy then the system is called clean exchange rate system.

Dirty exchange rate system is also called managed floating exchange rate system where the central bank intervenes in the foreign exchange markets by buying or selling the foreign currencies. In such a case, the exchange rate is managed or influenced by the intervention of the Central bank in the markets.

                  Depreciation and Devaluation

The terms devaluation and revaluation takes place under the system of fixed exchange rate syatem. A currency is devalued whenever its price is lowered by the central bank in terms of the foreign currency. Similarly a currency is revalued whenever its price is raised by the central bank with respect to the foreign currency. 

On the other and under flexible or floating exchange rates the terms used are depreciation and appreciation. A domestic currency is said to be depreciated whenever the foreign currency becomes more expensive in terms of domestic currency. Similarly, a domestic currency appreciates whenever it becomes expensive in terms of the foreign currency. 

For example if Indians have to pay more for buying a dollar then it is depreciation of Indian rupee and when we have to pay less for buying a dollar it is appreciation of Indian rupee.

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Differentiate between fixed and flexible exchange rate

               Fixed and Flexible Exchange Rate

Fixed Exchange Rate:

An exchange rate is defined as the value of one countries currency in terms of the other country’s currency. For example the exchange rate of Rupee in terms of dollar is around D 65  per US $. This is the nominal exchange which keeps on changing from time to time depending upon market conditions of two economies. The exchange rates may be either fixed or it may be flexible.

An exchange rate is said to be fixed whenever its value is fixed by the concerned authorities and the central bank of the economy stands ready to buy and sell its currency in the market at a fixed price in order to maintain the fixed exchange rate of its currency with respect to another currency. The Central Bank has to maintain excess reserves and be always ready to buy and sell the foreign currency as per the market conditions.

Whenever there is excess demand of foreign currency in the economy, the Central Bank can sell the foreign currency and purchase the domestic currency keeping the exchange rate constant.

Similarly, in case of excess supply of foreign currency, the Central Bank can buy this foreign currency and sell the domestic currency in the market, thereby again maintaining the exchange rate at a fixed level.

However, without the excess reserves, the Central bank can not intervene in the market and hence cannot maintain the exchange rate at a constant price.

Flexible or Floating Exchange Rate:

An exchange rate is said to be flexible or floating whenever its value is determined by the market forces of demand and supply. Here, the central bank has to allow exchange rate to float or adjust to the market conditions prevailing in the economy. The central bank of a particular country does not have to intervene in the market to maintain the exchange rate at fixed level. The market forces determine the exchange rate.

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