Final answer:
Reducing inflation from 5 percent to 2 percent with a sacrifice ratio of five requires a 15 percent loss of GDP over the adjustment period.
Step-by-step explanation:
To determine the output loss when the inflation rate is reduced from 5 percent to 2 percent using a sacrifice ratio of five, we use the formula for the sacrifice ratio: sacrifice ratio = (percentage points reduction in inflation) × (loss of output as a percentage of GDP per year). In this case, the inflation rate reduction is 3 percentage points (from 5 to 2 percent). Therefore, the total output loss is 3 × 5 = 15 percent of GDP spread over the period of adjustment.
In simple terms, a sacrifice ratio of five means that for each percentage point reduction in inflation, the economy must sacrifice 5 percent of annual output. For reducing inflation from 5 percent to 2 percent, which is a 3 percentage point reduction, would require a 15 percent output loss.