ReflationExplained, Advantages & Disadvantages, and Examples

Written By:
Lisa Borga

Reviewed By:
FundsNet Staff

Reflation is a term that is used to refer to the return of prices to an ordinary level in response to a recession and deflation.

It is also used to refer to monetary or fiscal policies which governments may use to stimulate economic activity following a downturn in the business cycle and ignite an expansionary phase of the business cycle.

This term acts in direct contrast to disinflation, which seeks to reduce economic activity in order to return an economy to its regular long-term trend.

Reflation Explained

Every economy experiences different stages of growth and decline associated with the business cycle.

These expansions and contractions in the economy are driven by many factors, including unemployment rates, consumer demand for goods and services, and market prices.

When unemployment rates increase, economic activity declines, and market prices drop, a phenomenon which is also referred to as deflation, an economy is undergoing a part of the business cycle referred to as contraction.

When this contraction drags on for an extended period, this contraction can become a recession, and in order to restore an economy to a state of growth, a government or central banks may implement reflationary policies intended to stimulate economic activity.

The reflationary policies will generally involve a mixture of fiscal and monetary policies, often including:

• Reduced Taxes: By reducing taxes, corporations and individuals will retain more of their money. A government intends for this increased wealth to be spent, boosting demand in the economy as well as prices.
• Increasing the Money Supply: Central banks may boost the amount of urgency and liquid instruments in an economy which will reduce the cost of money. This can generate more investment and place more money in the hands of consumers, which can be spent on increasing demand.
• Issue Stimulus Payments: A government may choose to distribute direct stimulus payments to consumers. These consumers may then spend these funds boosting demand in the economy.
• Reduced Interest Rates: By reducing interest rates, it becomes cheaper to borrow money and discourages storing money away in savings accounts. This encourages companies and individuals alike to spend more.
• Extended or Increased Unemployment Benefits: A contracting economy is associated with higher rates of unemployment. By increasing the duration or value of unemployment benefits, these individuals will retain greater spending power. This can, in turn, increase demand in the economy.
• Increased Investment in Capital Projects: A government may invest in large capital projects in order to create jobs, reduce unemployment rates, and provide consumers with increased spending power increasing demand.

All of these reflationary policies share something in common.

Specifically, they are intended to motivate individuals to spend more on the economy.

What Is a Period of Reflation?

After a government enacts reflationary policies, an economy will often undergo a period of reflation.

Reflation is marked by a return of an economy to long-term inflation trends as well as increasing wages, decreasing unemployment, and an increased rate of growth in a country’s gross domestic product.

When market prices increase, central banks will generally step in and increase interest rates to compensate for slowing down further growth.

The goal is to allow the economy to return to where it was before the contraction without further raising inflation during this expansionary period.

Reflation Example

A real-world example of reflation occurred in the United States economy as a result of the COVID-19 pandemic.

During the pandemic, many people were quarantined, causing a decrease in demand for goods and services.

As a result, businesses reduced their workforces, causing skyrocketing unemployment and economic contraction.

In response, the U.S. Congress and Federal Reserve took fiscal and monetary policy actions to stimulate the economy.

This included reducing federal interest rates, issuing multiple rounds of stimulus payments, increasing unemployment benefits, and more reflationary policies aimed at returning the economy to an expansionary stage.

Special Considerations

Reflationary policies have been used by many governments, including that of the U.S., in order to avoid or end contractionary periods in the business cycle.

No government has ever successfully avoided contractionary periods in their entirety, and many economists hold the belief that reflationary policies only harm an economy’s ability to recover.

Despite this, these policies continue to be widely used and supported by many economists and lawmakers.

Advantages & Disadvantages of Reflation

Advantages of Reflation

• This may result in a faster economic recovery and return to growth.
• It can potentially prevent high rates of deflation and unemployment.
• It can boost economic participation among businesses and consumers.
• Provides opportunities for employment to workers and higher rates of pay.
• Increasing demand in an economy leads to a corresponding increase in production.

Disadvantages of Reflation

• When performed excessively, reflationary policies can place too much money in certain parts of the economy while potentially still leaving others short.
• There is a risk of causing hyperinflation when reflationary policies are poorly planned.
• Increased government spending as a part of reflationary policies can cause a sharp increase in national deficits.

How Reflation Affects Investors

Reflation has a significant effect on the market as a whole as well as on certain sectors in particular.

In any case, investors see several unique investment opportunities as certain sectors that are particularly hard hit bounce back, such as travel, hospitality, and tourism, as well as often, to a lesser degree, energy and materials industries.

These investment decisions are often referred to as a “reflation trade.”

In addition, higher interest rates during a period of reflation can cause the prices of existing bonds to decrease as new bonds are issued at higher yields.

This phenomenon can lead some investors to sell bonds in anticipation of rising interest rates.

This can also occur in equity markets as investors anticipate a bull market.

Key Takeaways

• Reflation refers to the period immediately after an economic contraction, as well as policies enacted to stimulate economic activity and combat deflation.
• Reflationary policies are intended to stimulate spending, expand production, and curb deflation.
• Common reflationary policies include cutting taxes, increasing spending on infrastructure, increasing the money supply, and reducing interest rates.
• Generally, in the wake of reflationary policies, economies experience an upswing in the economic cycle.