This paper provides an investigation into the size and the precision with which we are able to estimate the cost of reducing inflation. That is, we examine our ability to measure the cumulative output loss arising from a permanent reduction in inflation commonly known as the "sacrifice ratio." In order to do this, we must identify shifts in monetary policy and evaluate their effects on output and inflation. For this purpose, we study the dynamics of output and inflation and derive an estimate of the sacrifice ratio based on measures of aggregate demand shocks and aggregate supply shocks.
We apply our estimation strategy to quarterly data for a group of eight industrial countries over the post-war period. While the estimates of the sacrifice ratio generally confirm the results in earlier investigations, we find that the estimates are very imprecise, suggesting that it is difficult to draw a reliable inference about its magnitude. Specifically, permanently reducing inflation by 1 percentage point leads to a cumulative loss (over several years) of 0.5 to 2.5 percent of one year's GDP. However, the estimates are sufficiently imprecise that we are unable to reject the hypothesis that the true value of the sacrifice ratio is equal to zero for the majority of countries in the study. Thus, while policymakers have the ability to infer estimates of the sacrifice ratio, the estimates provide a very unreliable guide for assessing the output cost of a disinflation policy.