Reflation

Updated on January 31, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Reflation Definition

Reflation is when the central bank takes various initiatives to reduce marginal lending rates with respect to its lending rate to commercial banks. In turn, it enhances the supply of funds in the economy, resulting in banks attaining greater liquidity. It also helps in boosting the economy by lowering the tax burden or increasing the supply of money.

Key Takeaways

  • Reflation means the Central Bank undertakes numerous initiatives to lessen marginal lending rates concerning lending rates to commercial banks. As a result, it increases the funds’ supply in the economy, resulting in banks arising greater liquidity.
  • It also helps increase the economy by minimizing the tax burden or escalating the money supply.
  • The components of reflation are lowering interest rates, lowering taxes, investing in large capital expenditures, and increasing the money supply.
  • It combines monetary and fiscal policy to overcome deflation or lower economic output.

Components of Reflation

The following are the components of reflation:-

Reflation Components

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#1 – Lower Interest Rates

In reflation, the central bank lowers their marginal lending rate for commercial banks, increasing the money supply in the economy as the banks have greater liquidity now. This leads to production and economic expansion.

#2 – Lowering Taxes

As every government charges taxes from citizens, it serves as revenue for the government. Therefore, 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 its citizens, which leads to an increase in the spending capacity of the people and an increase in consumption and consumer spending.

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#3 – Investing in Large Capital Expenditure

The government also runs a fiscal deficitFiscal DeficitFiscal deficit refers to the situation where the total budget expenditure exceeds the total budget receipts, excluding the government borrowings in a given fiscal year. It determines the amount the government needs to borrow for meeting its excess expenditure.read more in times of reflation where the economy is not expanding and jobs are not being created. But, again, this is because the government tends to do large CAPEXCAPEXCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more and invest in large infrastructure projects, leading to job creation and employment generation.

#4 – Increasing the Money Supply

The central banks and the government increase the money supply in the economy by adapting to certain monetary and fiscal measures. 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 examples.

Reflation

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Example #1

Imagine a country had an inflation rate of 2.5% in 2016. In 2017, the government was suddenly experiencing deflation of 2% due to non-existent customer demand and money supply in the economy.

It is a classic example of reflation, and the government should adopt various monetary and fiscal measures to bring back the country’s inflation to the target of 2%. In this case, the government should increase the money supply in the economy.

Example #2

Imagine a country in 2013 with an inflation rate of 1.5% in the said year. In 2017, the government was suddenly experiencing deflation of 2% due to non-existent customer demand and money supply in the economy.

It is a classic example of reflation, and the government should adopt various monetary and fiscal measures to bring back the country’s inflation to the target of 1.5%. In this case, the government should increase the money supply in the economy.

Advantages

  • Reflation increases the money supply in the economy and leads to economic expansion in the output.
  • Reflation also helps economies 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 tackling deflation and keeping inflation around the target mark.
  • Reflation also leads to lower interest rates. It can directly affect infrastructural and other economic activities, demanding heavy capital expenditure and having a long gestation period.
  • 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

Conclusion

Reflation combines monetary and fiscal policyFiscal PolicyFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more initiatives to combat deflation or lower economic output. It is usually done by increasing the money supply, lowering interest rates and tax rates, and investing in CapEx. When there is a state of deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more,or degrowth in the economy, the government adopts measures to restore the economy to normal levels.to normal levels.

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 economy’s money supply, should use the reflation tool to stimulate demand and consumer spending with great clarity and carefulness.

Frequently Asked Questions (FAQs)

What is reflation vs inflation?

Reflation happens when prices rise, and the economy is down, and not at complete employment. In comparison, inflation happens when prices rise after full economic employment. Reflation happens when the economy is in a recession or an economic downfall.

What are the types of reflation?

Reflation types are (1) increasing the money supply, (2) lowering taxes, (3) reducing interest rates, and (4) investing in large capital expenditure.

How is reflation measured?

Reflation is an economic recovery generally resulting from combined fiscal and monetary policy. Some standard reflation measures are direct stimulus funds, tax cuts, and interest rate reductions. The objective is to increase economic participation and overcome unemployment during the economic downfall.

What are the effects of reflation?

Reflation expands the available supply of money in the economy and boosts output. Also, it aids in the stabilization of economies in the aftermath of a harsh deflation. Also, it promotes financial employment through increased consumption.

Recommended Articles

It is a guide to what reflation is 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 –

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