Governments and central banks generally target an annual inflation rate of 2-3% in order to maintain economic stability and growth. If inflation "overheats" and prices rise too rapidly, restrictive or 'tight' monetary and fiscal policy tools are employed. If prices begin to fall generally, as is the case with deflation, 'loose' or expansionary monetary and fiscal policy tools are used. These sorts of tools, however, are potentially more difficult to employ due to technical and real-world limitations.
Deflation is a serious economic issue that can exacerbate a crisis and turn a recession into a full-blown depression. When prices fall and are expected to drop in the future, businesses and individuals choose to hold on to money rather than spend or invest. This leads to a drop in demand, which in turn forces businesses to cut production and sell off inventories at even lower prices.
Businesses layoff workers and the unemployed have more difficulty finding work. Eventually, they default on debts, causing bankruptcies and credit and liquidity shortages known as a deflationary spiral. This scenario is scary, and policymakers will do whatever is necessary to avoid falling into such an economic hole. Here are some ways that governments fight deflation.
Monetary Policy Tools
Lowering bank reserve limits
In a fractional reserve banking system, as in the U.S. and the rest of the developed world, banks use deposits to create new loans. By regulation, they are only allowed to do so to the extent of the reserve limit. That limit is currently 10% in the U.S., meaning that for every $100 deposited with a bank, it can loan out $90 and keep $10 as reserves. Of that new $90, $81 can be turned into new loans and $9 kept as reserves, and so on, until the original deposit creates $1000 worth of new credit money: $100 / 0.10 multiplier. If the reserve limit is relaxed to 5%, twice as much credit would be generated, incentivizing new loans for investment and consumption.
Open market operations
Central banks buy treasury securities in the open market and, in return, issue newly created money to the seller. This increases the money supply and encourages people to spend those dollars. The quantity theory of money states that like any other good, the price of money is determined by its supply and demand. If the supply of money is increased, it should become less expensive: each dollar would buy less stuff and so prices would go up instead of down.
Lowering the target interest rate
Central banks can lower the target interest rate on the short-term funds that are lent to and among the 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. Lowering rates makes it cheaper to borrow money and encourages new investment using borrowed money. It also encourages individuals to buy a home by reducing monthly costs.
When nominal interest rates are lowered all the way to zero, central banks must resort to unconventional monetary tools. Quantitative easing (QE) is when private securities are purchased on the open market, beyond just treasuries. Not only does this pump more money into the financial system, but it also bids up the price of financial assets, keeping them from declining further. (See also: Why Didn't Quantitative Easing Lead to Hyperinflation.)
Negative interest rates
Another unconventional tool is to set a negative nominal interest rate. A negative interest rate policy (NIRP) effectively means that depositors must pay, rather than receive interest on deposits. If it becomes costly to hold on to money, it should encourage spending of that money on consumption, or investment in assets or projects that earn a positive return. (For more, see: How Unconventional Monetary Policy Works.)
Fiscal Policy Tools
Increase government spending
Keynesian economists advocate using fiscal policy to spur aggregate demand and pull an economy out of a deflationary period. If individuals and businesses stop spending, there is no incentive for firms to produce and employ people. The government can step in as spender of last resort with hopes of keeping production going along with employment. The government can even borrow money to spend by incurring a fiscal deficit. Businesses and their employees will use that government money to spend and invest until prices begin to rise again with demand.
Cut tax rates
If governments cut taxes, more income will stay in the pockets of businesses and their employees, who will feel a wealth effect and spend money that was previously earmarked for taxes. One risk of lowering taxes during a recessionary period is that overall tax revenues will drop, which may force the government to curtail spending and even cease operations of basic services. There has been conflicting evidence as to whether or not general and specific tax cuts actually stimulate the real economy. (For more, see: Do Tax Cuts Stimulate The Economy?)
The Bottom Line
While fighting deflation is a bit more difficult that 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 outcomes that hurt everyone. By using expansionary fiscal and monetary tools, including some unconventional methods, falling prices can be reversed and aggregate demand restored.