Definition, How It Works, Example

  • Reflation is a phase of economic recovery that usually results from a combination of fiscal and monetary policies.
  • Direct stimulus funds, tax cuts, and interest rate cuts are some common reflationary measures.
  • The aim is to increase participation in the economy and fight unemployment due to a downturn.
  • Read more stories from Personal Finance Insider.

Every economy goes through cycles of growth and decline. These expansions and contractions are driven by a number of factors, including employment rates, the volume of goods and services being bought and sold, and market prices.

When employment, economic activity, and prices steadily decline, the economy is experiencing a contraction that could lead to a contraction


recession

. When this happens, officials often take steps to try to get the economy growing again – a process known as reflation.

What is reflation?

Reflation is a period of economic expansion that usually occurs as a result of fiscal and monetary policies. In the US, this came in the form of massive direct federal stimulus packages from Congress, along with historically low interest rates and other measures taken by the Federal Reserve to boost growth amid the coronavirus pandemic.

“Typically, those in power start with an income tax cut or the issuance of stimulus funds to prop up the struggling economy,” said Eddie Martini, strategic real estate investment advisor at real estate bees. “We’ve witnessed a lot of that in 2020 and 2021 in the US and many of the pandemic-hit countries around the world.”

How does reflation work?

Prices fall when the economy shrinks because demand falls. Businesses reduce production, resulting in less demand for labor, and people may lose their jobs or their incomes. This in turn leads them to keep their money instead of spending it. This can lead to deflation, which often lasts until it hits a bottom or bottom, and then corrects into a period expansion.

The government and central banks can step in to initiate reflation by adopting policies that bring more money into the economy by implementing fiscal and monetary policies. Fiscal policy refers to government decisions that affect taxes and spending. This may include sending money directly to consumers and cutting taxes to stimulate the economy and encourage reflation.

The idea is that businesses and consumers will spend more money when they have it, and the impact will be multiplied across the economy. Every dollar that the government spends or gives in the form of a tax cut will have a greater impact on the economy than the original dollar alone.

“If I get $100 from a government stimulus program that I then spend at a restaurant, the restaurant uses part of it to pay its employees, part to buy supplies, part to pay for utilities, and so on,” says Gene Balas, a chartered financial analyst and investment strategist at SEIA. “If an employee gets extra money from my tips or their paycheck, they can spend that money on a haircut or a new toaster oven, etc. many times across the economy.”

Monetary policy refers to actions taken by central banks to increase or decrease the money supply in the economy. As part of reflation, these banks can lower interest rates and open special programs that make it easier for businesses and consumers to borrow money. the


federal reserve

could also buy bonds to expand the money supply.

“The reflation happened during the Great Recession of 2007-2009,” says Dr. Ahmed Rahman, research associate at Lehigh University’s Department of Labor Economics. “The Federal Reserve increased bond buying and bought other assets such as mortgage-backed securities to stimulate economic activity and increase the US money supply. Congress also enacted several economic spending programs, such as the Troubled Asset Relief Program (TARP), to add capital to banks to encourage them to continue lending.”

Reflationary policies like these are often successful in increasing economic participation, job growth and reducing unemployment, price inflation and economic expansion. The goal is to bring the economy back to pre-contraction levels, but in a controlled manner so that inflation doesn’t spiral out of control.

“If the stimulus is excessive, reflation can turn into pure inflation as the economy is pushed beyond its long-term capacity and overheats,” says Rahman. “If the stimulus is lean, it can lead to sluggish subsequent price and income growth.”

example reflation

The US experienced an economic slowdown as a result of the coronavirus pandemic. People have been quarantined or told to stay at home, resulting in lower revenue and reduced demand for goods and services. Businesses suffered losses and had to lay off workers, causing unemployment to skyrocket.

In response, Congress and the Fed took fiscal and monetary action to remedy the situation and get the economy moving again.

fiscal policy measures

  • Direct incentive payments to consumers
  • Extended unemployment benefit in higher amounts
  • Loans and relief funds to local governments
  • Income tax deferral for companies
  • Child Tax Credit Advances from the IRS

monetary policy measures

  • The Federal Reserve cut interest rates and bought long-dated bonds
  • Direct government lending to businesses, such as the Paycheck Protection Program and the expansion of the Small Business Administration’s Economic Injury Disaster Loan Program
  • Relaxed regulatory requirements for banks

As a result of these policies, which triggered reflation, the economy staged a significant recovery. This was most evident in the unemployment rate. It had peaked at 14.8% in April 2020 and declined to around 3.8% in a little less than two years.

Pros and cons of reflation

Like anything related to economics, reflation has its pros and cons. Here are a few to consider

What is “reflation trading”?

Reflation opens up opportunities to invest in sectors related to the economic recovery. These tend to increase in value as demand for their goods and services increases.

“‘Reflation trading’ refers to an asset allocation approach that aims to capitalize on an economy’s successful emergence from a recession or period of slower growth in general,” says Peter C. Earle, Research Associate at American Institute for Economic Research. “This approach would typically favor selling government bonds and buying stocks that are performing well in the early stages of economic expansion.”

Reflation vs Inflation

Reflation refers to the implementation of measures to stimulate economic recovery following a contraction. It stimulates inflation but aims to do so in a controlled manner to increase consumer purchasing power and reduce unemployment.

Inflation refers to the increase in the prices of consumer goods and services over a period of time. It is the opposite of deflation and can be triggered by reflation. Like inflation, inflation can be a positive thing if controlled. Too much inflation can lead to reduced purchasing power, which means you can buy less with the money you have to spend.

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