Volcker Disinflation
What is Volcker Disinflation?
The Volcker disinflation was the Federal Reserve's early-1980s campaign that broke double-digit inflation by accepting a deep recession to gain credibility.
By the end of the 1970s American inflation had reached double digits and people expected it to stay high, so the expectation was built into wage and price setting. Under Paul Volcker the Federal Reserve tightened hard, targeting money growth and letting short-term interest rates climb toward 20 percent, and the economy fell into what was then the worst recession since the Second World War, with unemployment reaching nearly 11 percent. Inflation came down quickly, to roughly 4 percent within a few years, and it stayed down. In Phillips curve terms, the tightening first moved the economy down along the short-run curve, and only as expected inflation fell did that curve shift down so unemployment could return to its natural rate. The episode is the standard case study in the cost of buying credibility.
Volcker Disinflation: a worked example
Economists measure the price of a disinflation with the sacrifice ratio. Suppose inflation falls from 10 percent to 4 percent, a drop of 6 percentage points, while output runs about 3 percent below potential for four years. Cumulative lost output is 3 × 4 = 12 percent of one year's GDP, so the sacrifice ratio is 12 ÷ 6 = 2, meaning each percentage point of inflation removed cost about 2 percent of a year's output. The ratio is smaller when the public believes the central bank, because expected inflation then falls without a recession forcing it down. That is the practical value of a credible inflation target.
The mistake students make with volcker disinflation
Students often conclude that Volcker proved fighting inflation is painless if a central bank is simply tough enough. The opposite is closer to the truth: it took a severe recession precisely because the public did not yet believe the Fed would follow through, and enduring that pain is what made later announcements believable. A second confusion is between disinflation and deflation. Inflation fell but prices kept rising, only more slowly.
Volcker Disinflation questions
What is disinflation?
Disinflation is a fall in the rate of inflation while prices are still rising, which is different from deflation, where the price level itself falls. Inflation dropping from 9 percent to 3 percent is disinflation, and the cost of living is still going up, just more slowly. Deflation means the average price is lower than it was a year earlier.
Why did the Volcker disinflation cause a recession?
The Volcker disinflation caused a recession because sharply higher interest rates cut interest-sensitive spending on housing, cars and business equipment, shifting aggregate demand left. With wages and expected inflation still set for high inflation, the fall in demand showed up first as lost output and lost jobs rather than lower prices. Only once expectations came down did inflation keep falling without further pain.
What is the sacrifice ratio?
The sacrifice ratio measures how much output a country gives up to lower inflation by one percentage point, expressed as a share of a single year's national output. A higher ratio means disinflation is more expensive, which is why central banks weigh it when deciding how fast to tighten. Estimates from real episodes vary a good deal, so it is best read as an order of magnitude rather than a precise number.
Formula / Example
This is the live Phillips Curve sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated