Reflation is what's intended to happen when officials move to pull the economy out of a recession

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

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

When there is a steady decrease in employment, economic activity, and prices drop, the economy experiences a contraction that could lead to


recession

. When this happens, officials often take steps intended 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 the massive direct federal stimulus packages by Congress, as well as historically low interest rates and other measures the Federal Reserve took to spur growth amid the coronavirus pandemic.

“Usually the powers that be will start with an income tax cut or issuing of stimulus funds to help prop up the failing economy,” says Eddie Martini, strategic real estate investment advisor at Real Estate Bees. “We witnessed a lot of this in 2020 and 2021 in the US and many countries throughout the world affected by the pandemic.”

How does reflation work? 

Prices go down as the economy contracts because demand decreases. Companies reduce output, which results in less need for labor, and people can lose their jobs or have their income decrease. This, in turn, causes them to hold on to their money instead of spending it. This can cause deflation that will often continue until it reaches a low point or trough, then it corrects into a period expansion. 

The government and central banks can step in to begin reflation by taking actions that put more money into the economy by implementing fiscal and monetary policies. Fiscal policy refers to government decisions that impact taxation and spending. This can include sending money directly to consumers and lowering taxes to stimulate the economy and jumpstart reflation. 

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

“If I receive $100 from a government fiscal stimulus spending program that I then spend at a restaurant, the restaurant will use some of it to pay its employees, some of it to buy supplies, some of it to pay for utilities, and so on,” says Gene Balas, a chartered financial analyst and investment strategist with SEIA. “If an employee receives extra funds from my tip or their paycheck, they can then spend that money on a haircut or a new toaster, etc. And that business, in turn, can use those additional funds to increase spending even more, when multiplied many times across the entire economy.” 

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


Federal Reserve

might also buy bonds as a means to expand the money supply.     

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

Reflation policies like these are often successful at increasing participation in the economy, job growth and lowered unemployment rates, price inflation, and economic expansion. The goal is to get the economy back to where it was before the contraction, but to do it in a controlled way so that inflation doesn’t get out of control.    

“If stimulus is excessive, reflation can morph into straight-up inflation as the economy is pushed beyond its long-term capacity and overheats,” says Rahman. “If stimulus is meager, it can result in sluggish subsequent price and income growth.”

Reflation example 

The US experienced an economic contraction as a result of the coronavirus pandemic. People were quarantined or urged to stay home, which resulted in lower earnings and decreased demand for goods and services. Businesses suffered losses and had to lay off employees, causing unemployment to skyrocket. 

In response, Congress and the Fed implemented fiscal and monetary policy actions to help provide relief and get the economy moving upward again. 

Fiscal policy actions

  • Direct stimulus payments to consumers
  • Extended unemployment benefits at greater amounts
  • Loans and aid fund sent to local governments  
  • Payroll tax deferment for businesses
  • Advance Child Tax Credit Payments from the IRS

Monetary policy actions

  • Federal Reserve lowered interest rates, bought long-term bonds
  • Direct government loans 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 policy actions creating reflation, the economy experienced significant recovery. That was seen most apparently in the unemployment rate. It had reached a peak of 14.8% in April 2020 and declined to about 3.8% in a little less than two years. 

Pros and cons of reflation

Like anything related to the economy, there are advantages and disadvantages to reflation. Here are a few to consider

What is the ‘reflation trade’?

Reflation opens up opportunities to invest in sectors involved with economic recovery. These tend to grow in value as demand for their goods and services grow.    

“The ‘reflation trade’ refers to an investment allocation approach which seeks to take advantage of the successful emergence of an economy from a recession or period of slowing growth more generally,” says Peter C. Earle, research fellow at American Institute for Economic Research. “That approach would usually favor selling Treasury securities and buying stocks which perform well in the early part of economic expansions.”

Reflation vs. inflation

Reflation refers to the implementation of policies to stimulate economic recovery as a result of contraction. It jump-starts inflation, but aims to do so in a controlled way that increases consumer buying power and decreases unemployment. 

Inflation refers to the increase in prices of consumer goods and services over a set period of time. It’s the opposite of deflation and can be initiated through reflation. Like reflation, inflation can be a positive thing if it is controlled. Too much inflation can result in decreased buying power, meaning you can purchase less with the money you have to spend.

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