What is Reflation? Definition, 5 Methods & the Difference from Inflation

By Chika

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Last Updated: October 4, 2022

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Every economy experiences cycles of growth and decline.

These expansions and contractions are fueled by several factors, including:

  • employment rates
  • the number of goods and services being bought and sold
  • market prices

Growth cycles are characterized by an increase in employment activity, high consumer spending, high employment rate, and business expansion. On the flip side, a contracting economy is characterized by a decrease in employment, low economic activity, and weak consumer spending.

When an economy suffers a recession, pullback, or a period of uncertainty, deflation – or a period of falling prices – can usually be the result.

The effect of economic contraction usually entices policymakers into action to stimulate the economy. The actions taken by policymakers to stimulate the economy is known as reflation.

In this article, we take a deep dive into reflation and how you can understand it better. 

 

 

What is Reflation? 

Reflation is the term used to describe the rise in prices following an economic downturn.

When the economy experiences reflation, demand increases as a result of economic stimulus, pushing prices higher. There is always a chance that reflationary policies could overreach and result in long-term inflationary tendencies even while they aim to bring deflationary economies back into positive territory.

The goal of reflation is to halt deflation, which is the overall drop in prices for goods and services that happens when inflation falls below 0%. It is a long-term change that aims to lessen any excess labor market capacity and is frequently characterized by a sustained reacceleration in economic development.

Reflationary policies frequently result in higher economic involvement, job growth, decreased unemployment rates, price inflation, and economic growth. The objective is to restore the economy to its pre-recession level while doing so in a controlled manner to prevent inflation from spiraling out of control.

 

5 Reflation Methods

There are various methods that policymakers could use to reflate the economy. Here are a couple of them.

1. Reducing taxes.

Less taxation increases the wealth of businesses and workers. The expectation is that increased income will be invested in the economy, driving up demand and product costs.

 

2. Lowering interest rates.

Central banks can lower interest rates to increase the money supply in the economy.

This makes it cheaper to borrow money and less rewarding to stow capital away in savings accounts, thereby encouraging people and businesses to spend more freely to stimulate the economy. 

 

3. Change in monetary policy.

Central banks can decide to boost the amount of currency and other liquid instruments in the banking system.

The cost of money falls, generating more investment and putting more money in the hands of consumers.

 

4. Capital projects.

Large investment projects create jobs, boosting employment figures and the number of people with spending power.

 

5. Fiscal stimulus.

Congress can decide to approve a fiscal stimulus to boost consumer spending.

This helps businesses to stay afloat and households to be able to afford their necessities.

 

How do reflation policies work?

Reflation often happens when governments and central banks offer stimulus to boost economic growth.

To increase economic activity, a central bank like the Federal Reserve can implement monetary stimulus.

To increase the amount of money available, the Federal Reserve could, for instance, cut interest rates and purchase bonds. Additionally, it can roll out initiatives like direct lending to small and medium-sized non-financial firms.

The quantity of money that banks have available to lend to customers and businesses would rise as a result of all of these monetary policy initiatives. The economy would move closer to full employment as a result of increasing demand and more people working.

By giving money to small firms or making direct payments to consumers, Congress can also use fiscal stimulus to boost economic activity. This will increase the amount of money accessible in the economy.

 

 

Examples of Reflation Strategies

After the Great Recession, the American economy remained weak, and the Federal Reserve (FED) found it difficult to instigate inflation, despite using several reflationary monetary policy instruments, such as reduced interest rates and an expansion of the money supply.

However, the Great Recession was overcome by the 2009 passage of the American Recovery and Reinvestment Act (ARRA), the Troubled Asset Recovery Plan (TARP), and the Trump Tax Cut. US economic growth from 2009 to 2019 was 2.3%. The term "Trump Reflation Trade" originated from Trump's aggressive initiatives.

A more classic example is the reflation policies to soften the blow of the economic shutdown due to the pandemic.

To boost the economy's banking sector and inject cash into the economy from 2020 through the majority of 2021, the Federal Reserve purchased bonds. Additionally, it has loosened bank regulatory standards and directly lent money to state governments and non-financial firms. 

Additionally, Congress extended jobless benefits, directed payments to individuals, and provided loans to local governments. Together, these steps have brought the economy back up to full employment while causing reflation.

 

 

Reflation vs. Inflation

It's critical to distinguish between inflation and reflation.

Contrary to popular belief, reflation is not a bad thing as the economy is being stimulated through various methods to achieve full employment and growth. 

On the other hand, inflation is frequently seen negatively because it is characterized by price increases when the economy is operating at capacity.

As such, reflation can be viewed as inflation that is controlled to lift an economy out of depression.

 

 

Final word

There are mounting fears that the economy could slide into recession, and the economic signs are tale-telling.

The bond market has flashed an inverted yield curve, businesses are laying off workers or halting employment, the Fed increasing rates at its most aggressive pace in over 40 years, and weak earnings forecasts from companies. 

If the economy eventually goes into recession, the Federal Reserve and policymakers would be faced with a new problem, how to pull the economy from depression.

To achieve this, a couple of policies would have to be put in place to kick-start the economy. Depending on the reflationary method, the effects on the economy could be slow or fast. 

However, no matter the method, reflation strategies are always welcome as it tends to boost economic growth. 

Photo by Markus Spiske

 

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