The governments and central banks generally aim for a year inflation rate of 2 to 3% in order to maintain economic stability and growth. If inflation is “overheating” and prices are rising too quickly, restrictive or “tight” monetary and tax political tools are used. If prices begin to fall generally, such as in deflation, “looseness” or expansion monetary and fiscal policy tools are used. However, these types of tools are potentially more difficult to use due to technical and real-world limitations.
Key points to remember
- Deflation occurs when price levels in an economy fall, where people prefer to hoard money instead of spending it on goods that will be cheaper in the future.
- As a result, deflation can bring an economy to a halt – and so central banks and governments try to fight inflation when it happens.
- Here we look at some monetary and fiscal policy tools that can be used to fight deflation and prevent prices – and economic activity – from spiraling lower.
Deflation is a serious economic problem that can exacerbate a crisis and transform a recession in a real depression. When prices fall and are expected to fall in the future, businesses and individuals choose to hold onto their money rather than spend or invest. This leads to lower demand, forcing companies to cut production and sell inventory at even lower prices.
Companies Fire workers and the unemployed have more difficulty finding work. Eventually they default on debts, causing bankruptcies and credit and liquidity shortages known as deflationary spiral. This scenario is frightening and policy makers will do whatever is necessary to avoid falling into such an economic abyss. Here are some ways governments fight deflation.
Monetary policy tools
Lower bank reserve limits
In a fractional reserve bank system, as in the United States and other developed countries, banks use deposits to create new loans. By regulation, they are only allowed to do so within the limit of the reserve limit. This limit is usually set at around 5-10% in the US, which means that for every $100 deposited with a bank, it can lend out $90 and keep $10 in reserve. Of that new $90, $81 can be turned into new loans and $9 kept as reserves, and so on, until the initial deposit creates $1,000 of new loans. credit money: $100 / 0.10 multiplier. If the reserve limit is relaxed to 5%, twice as much credit would be generated, prompting new lending for investment and consumption.
Effective March 26, 2020, the Federal Reserve reduced reserve requirements for most commercial banks to 0% and eliminated reserve requirements for all depository institutions.The purpose of this decision was to move to a regime of abundant reserves.This removes the need for thousands of depository institutions to maintain balances in reserve bank accounts to meet reserve requirements, thereby freeing up liquidity in the banking system to support lending to households and businesses.
Open market operations (OMO)
Central banks are buying treasury securities in the open market and, in return, issue newly created money to the seller. This increases the money income and encourages people to spend those dollars. The quantity theory of money states that like any other good, the price of silver is determined by its supply and demand. If the supply of money increases, it should become cheaper: each dollar would buy fewer things and prices would rise instead of fall.
Lowering of the target interest rate
Central banks can lower the target interest rate on short-term funds that are loaned to and between financial sector. If this rate is high, it will cost the financial sector more to borrow the funds needed to meet day-to-day operations and obligations. Short-term interest rates also influence longer-term rates, so if the target rate is raised, long-term money, such as mortgage loans, also becomes more expensive. Lower rates make borrowing cheaper and encourage new investments using borrowed money. It also encourages individuals to buy a home by reducing monthly costs.
When nominal interest rates are lowered to zero, central banks have to resort to unconventional monetary tools. Quantitative easing (QE) corresponds to the purchase of private securities on the open market, beyond Treasury bills. Not only does this inject more money into the financial systembut it is also auction increase the price of Financial assetspreventing them from declining further.
Negative interest rates
Another unconventional tool is to set a negative value nominal interest rate. A negative interest rate policy (NIRP) effectively means that depositors must pay, rather than receive interest on deposits. If it becomes expensive to hold money, it should encourage the spending of that money for consumption or investment in assets or projects that generate a positive return.
Fiscal policy tools
Increase in public spending
Keynesian economists advocate using fiscal policy to stimulate aggregate demand and pull an economy out of a deflationary period. If individuals and businesses stop spending, there is no incentive for businesses to produce and employ people. The government can step in as a spender of last resort in the hope of maintaining output and employment. The government can even borrow money to spend by hiring a deficit. Businesses and their employees will use this government money to spend and invest until prices start to rise again with demand.
Reduce tax rates
If governments cut taxes, more revenue will stay in the pockets of businesses and their employees, who will feel wealth effect and spend money that was previously intended for taxes. One of the risks of cutting taxes in a recession is that overall tax revenues will fall, which could force the government to cut spending and even cut basic services. There has been conflicting evidence as to whether or not general and specific tax cuts actually stimulate the real economy.
Although fighting deflation is a little more difficult than containing inflation, governments and central banks have an array of tools they can use to stimulate demand and economic growth. The risk of a deflationary spiral can lead to a cascade of negative consequences that harm everyone. By using expansionary fiscal and monetary tools, including some unconventional methods, lower prices can be reversed and aggregate demand restored.