Reflation refers to the combination of monetary and fiscal policy initiatives aimed to combat the effect of deflation or lower economic output and is usually done by increasing the money supply, lowering interest rates and tax rate and investing in CapEx. When there is a state of deflation or there is degrowth in the economy the government adopts measures of Reflation in order to restore the economy back to normal levels.
Components of Reflation
The following are the components of Reflation:-
#1 – Lower Interest Rates
In the scenario of reflation, the central bank lowers their marginal lending rate the rate it lends to commercial banks which in turn increase the money supply in the economy as the banks have greater liquidity now on their hands and also leads to production and economy expansion
#2 – Lowering Taxes
As every government charge taxes from the citizen of their country, it serves as revenue for the government. In case of reflation when the commodity prices are low and no expansion is taking place in the economy the government tends to decrease the tax rate which it charges from his citizens which leads to an increase in the spending capacity of the people and also leads to increase in consumption and consumer spending
#3 – Investing in Large Capital Expenditure
The government also runs a fiscal deficit in the times of reflation where the economy is not expanding and jobs are not being created. The government in these times tends to do large capital expenditure and invest in large infrastructure projects which in turn leads to job creation and employment generation
#4 – Increasing the Money Supply
The central banks and the government increases the money supply in the economy by adapting to certain monetary and fiscal measure the above points are all examples of increasing the money supply in the economy
Calculation of Reflation with Examples
We can better understand the concept of Reflation with the help of an example
Imagine a country in 2016 has an inflation rate of 2.5% in the said year and now in 2017 the country is suddenly experiencing deflation of 2% due to non-existent customer demand and money supply in the economy.
This is a classic example of reflation and the government should adopt various monetary and fiscal measure to bring back the country inflation to the target of 2%. In this case, the government should increase the money supply in the economy
Imagine a country in 2013 has an inflation rate of 1.5% in the said year and now in 2017 the country is suddenly experiencing deflation of 2% due to non-existent customer demand and money supply in the economy.
This is a classic example of reflation and the government should adopt various monetary and fiscal measure to bring back the country inflation to the target of 1.5%. In this case, the government should increase the money supply in the economy
Advantages of Reflation
- Reflation increase the money supply in the economy and leads to economic expansion in the output
- Reflation also helps economies to get stabilize the re-run themselves after a steep deflation has occurred in the economy
- It also helps the creation of employment in the economy through increased consumption
- It also helps in tacking deflation and keeping inflation around the target mark
- Reflation also leads to lower interest rates so that it can directly affect the infrastructural and other activities in the economy which demands heavy capital expenditure and has a long gestation period in the economy
- Reflation also leads to an increase in the manufacturing and the production index as more and more factories are being set up to meet the increasing consumer demand and output
Disadvantages of Reflation
- Reflation can lead to the excessive money supply in the economy and can also lead to hyperinflation sometimes in the economy if it is not managed correctly
- Reflation leads to government fiscal deficit which means that the government need to borrow external funds from other countries to increase the money supply in the economy
- Reflation can lead to heavy debt and overlending by the commercial and the public banks in the economy which can lead to non-performing assets in the banking industry
Hence, reflation has both advantages and disadvantages and it is like the two sides of the same coin and therefore the government in discussion with the apex bank of the country which is regulating the money supply of the economy should use the reflation tool to stimulate demand and consumer spending with great clarity and carefulness.
This has been a guide to what is reflation and its definition. Here we discuss Reflation components and see how it affects the economy along with examples, advantages, and disadvantages. You can learn more about financing from the following articles –