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Continued from A1...

     A deflationary spiral is a situation where decreases in the price level lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in the price level. Since reductions in general price level are called deflation, a deflationary spiral occurs when reductions in price lead to a vicious circle, where a problem exacerbates its own cause. In science, this effect is also known as a positive feedback loop. Another economic example of this situation in economics is the bank run.

     The Great Depression was regarded by some as a deflationary spiral. A deflationary spiral is the modern macroeconomic version of the general glut controversy of the 19th century. Another related idea is Irving Fisher's theory that excess debt can cause a continuing deflation.

     Until the 1930s, it was commonly believed by economists that deflation would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention.During severe deflation, targeting an interest rate (the usual method of determining how much currency to create) may be ineffective, because even lowering the short-term interest rate to zero may result in a real interest rate which is too high to attract credit-worthy borrowers. In the 21st-century negative interest rate has been tried, but it can't be too negative, since people might withdraw cash from bank accounts if they have negative interest rate. Thus the central bank must directly set a target for the quantity of money (called "quantitative easing") and may use extraordinary methods to increase the supply of money, e.g. purchasing financial assets of a type not usually used by the central bank as reserves (such as mortgage-backed securities). Before he was Chairman of the United States Federal Reserve, Ben Bernanke claimed in 2002, "...sufficient injections of money will ultimately always reverse a deflation",  although Japan's deflationary spiral was not broken by the amount of quantitative easing provided by the Bank of Japan.

     This view was challenged in the 1930s during the Great Depression. Keynesian economists argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending. Reserve requirements from the central bank were high compared to recent times. So were it not for redemption of currency for gold (in accordance with the gold standard), the central bank could have effectively increased money supply by simply reducing the reserve requirements and through open market operations (e.g., buying treasury bonds for cash) to offset the reduction of money supply in the private sectors due to the collapse of credit (credit is a form of money).

     With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates (i.e., reducing the "cost" of money). This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early 1990s and in 2000–02, respectively. Austrian economists worry about the inflationary impact of monetary policies on asset prices. Sustained low real rates can cause higher asset prices and excessive debt accumulation. Therefore, lowering rates may prove to be only a temporary palliative, aggravating an eventual debt deflation crisis.

With interest rates near zero, debt relief becomes an increasingly important tool in managing deflation.