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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