Reflation

A fiscal or monetary policy (or policies) aimed towards stimulating the economy and combating deflation

What is Reflation?

Reflation refers to a fiscal or monetary policy (or policies) aimed towards stimulating the economy (i.e., increasing the level of economic activity) and combating deflation. It is used to restore long-run inflation, reduce the time span of an economic contraction, or reignite an expansionary business cycle. Reflation may also be used to describe the period immediately following a period of economic contraction.

Summary

• Reflation refers to policies aimed at stimulating the economy and combating deflation.

• Reflation policies include: (1) increasing the money supply, (2) lowering the tax rate, (3) reducing interest rates, and (4) investing in large capital projects.

• After the enactment of reflationary policies, the economic cycle generally experiences an upswing.

Understanding Reflation and Common Reflation Policies

During an economic contraction, there is often deflationary pressure on prices. Deflationary pressures are caused by lower aggregate demand, which causes firms to reduce their output and/or prices.

To re-stimulate the economy, the government and/or central bank enacts policies aimed at increasing economic participation. Reflation policies that may be enacted include:

• Increasing the money supply, which puts more money into the hands of consumers, thereby creating more liquidity in the economy.

• Lowering the tax rate, which makes firms and employers wealthier with hopes that they will inject that money into the economy.

• Reducing interest rates, which makes the cost of borrowing cheaper, thereby creating more liquidity in the economy.

• Investing in large capital projects, with the aim of creating more jobs and providing more people with spending power.

There is a commonality between all of the policies listed above – to motivate individuals to spend more on the economy.

What Happens to the Economy after a Reflation Policy?

After the enactment of reflationary policies, the economic cycle generally experiences an upswing, characterized by (1) an increasing consumer price index, (2) increasing wages, (3) a higher gross domestic product growth rate, and (4) a declining unemployment rate.

The following graphic outlines where reflation would be positioned in a theoretical economic cycle:

Real-Life Examples

During the onset of the coronavirus pandemic in early 2020, developed economies witnessed an economic contraction. In the U.S., examples of reflation implemented by both the government and central bank include:

• The Federal Reserve cutting the federal funds rate to a range of 0% to 0.25%

• The Federal Reserve launching a $700 billion quantitative easing program

• The U.S. Treasury Department signing the $1.8 trillion CARES Act

Advantages of Reflation

• An increase in the money supply, leading to an economic expansion;

• Stabilization of the economy after deflationary pressures;

• An increase in domestic manufacturing as consumer demand and output rises; and

• Greater employment opportunities and higher wages for workers.

Disadvantages of Reflation

• Potentially creating excessive money supply in the economy;

• Potentially leading the economy to hyperinflation if poorly managed;

• Greater government deficit if reflation involves monetary policies; and

• Potentially over-leveraged commercial and public banks.