Reflation: Definition as Monetary Policy, Methods, and Example

What Is Reflation?

Reflation is a fiscal or monetary policy designed to expand output, stimulate spending, and curb the effects of deflation, which usually occurs after a period of economic uncertainty or a recession. The term may also be used to describe the first phase of economic recovery after a period of contraction.

Understanding Reflation

Reflation aims to stop deflation—the general decline in prices for goods and services that occurs when inflation falls below 0%. It is a long-term shift, often characterized by a prolonged reacceleration in economic prosperity that strives to reduce any excess capacity in the labor market.

Reflation Methods

Reflation policies typically include the following:

• Reducing taxes: Paying lower taxes makes corporations and employees wealthier. It is hoped that extra earnings will be spent in the economy, lifting demand and prices for goods.
• Lowering interest rates: Makes it cheaper to borrow money and less rewarding to stow capital away in savings accounts, encouraging people and businesses to spend more freely.
• Changing the money supply: When central banks 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.
• Capital Projects: Large investment projects create jobs, boosting employment figures and the number of people with spending power.

In short, reflationary measures aim to lift demand for goods by giving people and companies more money and motivation to spend more.

Special Considerations

Reflation policy has historically been used by American governments to try and restart failed business expansions. Although almost every government tries in some form or another to avoid the collapse of an economy after a recent boom, none have ever succeeded in being able to avoid the contraction phase of the business cycle. Many academics believe government agitation only delays the recovery and worsens the effects.

Example of Reflation

In the wake of the Great Recession, the U.S. economy remained subdued and the Federal Reserve (FED) struggled to create inflation, even after utilizing several reflationary monetary policy tools, such as lower interest rates and increased money supply. However, the enactment of the Troubled Asset Recovery Plan (TARP) and the American Recovery and Reinvestment Act in 2009 as well as the Trump Tax cut in 2017 led to a recovery from the Great Recession.

The US economy grew by 2.3% from 2009 to 2019. Trumps' ambitious policies led to the term "Trump Reflation Trade." The trade? Buying equities and selling bonds.

Reflation vs. Inflation

It is important not to confuse reflation with inflation. Firstly, reflation is not bad. It is a period of price increases when an economy is striving to achieve full employment and growth.

Inflation, on the other hand, is often considered bad as it is characterized by rising prices during a period of full capacity. G.D.H. Cole once said, "reflation may be defined as inflation deliberately undertaken to relieve a depression."

Additionally, prices rise gradually during a period of reflation and fast during a period of inflation. In essence, reflation can be described as controlled inflation.