Despite the severity of the recent financial crisis and recession, the U.S. economy was able to avoid falling into an even more damaging deflationary spiral. Since mid-2009, the economy has been on a path of economic recovery. However, the pace of economic growth during the recovery has been relatively slow and major economic weaknesses persist. In this economic environment, the risk of deflation, albeit reduced from what it was during the previous period of economic contraction, remains significant and could be a potential threat to achieving sustained economic recovery. Deflation is a decline in the overall level of prices. It is not unusual for prices to fall in a particular sector because of rising productivity, falling costs, or weak demand relative to the wider economy. For example, although the overall price level of the U.S. economy from 1998 through 2008 increased about 34%, computer prices over the same period fell nearly 76% because production costs steadily fell. Similarly, because of weak demand, the price of gasoline fell about 28% in 2009. But such declines are rarely a problem for the overall economy and do not constitute deflation. Deflation occurs when price declines are so widespread and sustained that they cause a broad-based price index such as the Consumer Price Index (CPI) to steadily decline for more than several quarters. A continuous decline in the price level is more troublesome because in a weak or contracting economy it can lead to a damaging, self-reinforcing, downward spiral of prices and economic activity. Financial crises, in particular, tend to be deflationary because increased economic uncertainty increases the demand for cash (liquidity) by banks and financial institutions, constricting the flow of credit to households and businesses, and dampening their credit-supported spending. The slowing of current expenditure will exert downward pressure on the current price level. If current prices start to fall, households and businesses may come to expect the future price level to also fall. If the current price level is widely seen to be too high relative to the expected future price level, they are likely to postpone current purchases until prices fall further, leading to further slowing of current expenditure and current economic activity. A self-reinforcing dynamic could be set in motion that will amplify the decline of prices and output. The economy may ultimately reach a point at which the current price level has fallen sufficiently (i.e., sufficient deflation has occurred) relative to the expected future price level to boost current spending. But the fall of economic activity needed to cause that change in expectations could be protracted and costly, involving large output losses and high rates of unemployment. Japan's deflation in the 1990s is a recent example of the possible economic cost of a steadily falling price level. From 1992 through 2001, Japan's price level fell 0.5% per year on average and real gross domestic product (GDP) growth averaged only 1.0% per year. This compares to average growth rates for the Japanese economy of 4% to 5% in the 1970s and 1980s. A more pointed example of deflation's malign effect on economic activity was the experience of the United States in the Great Depression of the 1930s. From the 1929 stock market crash to the economy hitting bottom in 1933, the price level fell about 25%, real GDP fell about 30%, and the unemployment rate increased from 4% to near 25%. However, there are also examples of relatively benign deflations when economic activity expanded despite a falling price level. For instance, from 1880 through 1896, the U.S. price level fell about 30%, but this coincided with a period of strong economic growth, with real GDP advancing 5.0% per year on average. More recently, China, from 1998 through 2003, achieved particularly rapid economic growth along with a steadily falling price level. Whether a deflation is on balance malign or benign most often will hinge on whether the force generating the falling price level is collapsing aggregate demand or accelerating aggregate supply. Both forces exert downward pressure on the price level but have opposite effects on the level of economic activity. The U.S. deflation in the late 19 th century and that of China over the last decade occurred because aggregate supply was expanding faster than aggregate demand, exerting downward pressure on the price level but also causing output and employment to increase. Such positive supply-side shocks typically emanate from technological innovation, rising productivity, or trade liberalization. In contrast, Japan's recent deflation and the U.S. deflation in the 1930s occurred because of shortfalls of aggregate demand, exerting downward pressure on the price level, along with reducing output and employment. Such a negative demand shock could be caused by a severe cyclical downturn, the bursting of an asset price bubble, or overly tight macroeconomic policies. Congress actively participated in the policy responses to the recent financial crisis and recession and has an ongoing interest in macroeconomic conditions. Of current concern is the sustainability of the current economic recovery, and intertwined with that is concern about the lingering risk of deflation. Several channels exist through which deflation generated by a negative demand shock can dampen economic activity. First, if nominal prices of inputs, particularly wages, tend to fall slowly, a falling price level will increase the " real " cost of inputs , raising the unit cost of production. The combination of falling product prices and rising production costs narrows profit margins and causes firms to reduce production and employment. The degree of inflexibility of nominal input prices will determine the size of this dampening effect caused by deflation—the more inflexible input prices are, the larger the decline in output and employment will be. Second, a negative demand shock deflation will tend to increase " real " interest rates , dampening credit-supported economic activity, such as business investment, consumer durables, education, and housing. To understand this adverse process, it is necessary to recognize that "nominal" interest rates, the rate the lender charges the borrower, most often reflect two components: a real return to saving and an adjustment for the expected change in the price level. The nominal interest rate measures the cost of a loan in dollars, whereas the real interest rate measures the cost in terms of actual purchasing power. Therefore, if the nominal interest rate is 5% and there is the expectation of a 3% inflation, then the real interest rate is 2%. If there were an increase in the expected rate of inflation, the nominal rate would tend to rise proportionately to preserve purchasing power and leave the real interest rate unchanged. Moreover, there is no upper bound to nominal interest rates in response to a rising rate of inflation. In contrast, with deflation, nominal interest rates would tend to fall, and if the expected rate of deflation is equal to or greater than the real interest rate, the nominal rate would fall to zero. However, the nominal interest rate will not fall below zero because lenders would not accept a negative interest rate on a loan when they could instead just hold cash. For borrowers, however, with the nominal rate at zero, the real interest rate on a loan will equal the expected rate of deflation. For example, if the rate of deflation is 5%, then the real cost of funds borrowed at a zero nominal interest rate would be 5%. If the expectation of deflation rises to 10%, then the real cost of borrowing rises to 10%. For this reason, even though the nominal cost of borrowing is zero, a deflation can raise the real cost of borrowing to prohibitive levels, causing decreases in credit-supported spending by businesses and households that cause economic activity to slow further. For example, nominal interest rates declined to near zero over the course of the economic decline from 1929 to 1933; but because of the rapidly falling price level real interest rates increased sharply, and accordingly interest-sensitive spending by businesses and households plummeted. Third, a negative demand-shock deflation will increase the real debt burden of businesses and households that already hold debt. The burden rises as the price level falls because debtors will be repaying the loan principal with dollars of rising real value. With deflation induced by a negative demand shock, it is unlikely that the debtor's rising debt burden would be offset by an increased capacity (increased profits or increased wages) to service the debt. Moreover, if the deflation is accompanied by falling asset prices, the real losses of debtors will not be the gains of creditors because the collateral held by lenders likely will also be losing value. In an environment of rising debt burdens and falling collateral value, delinquencies, defaults, and bankruptcies will increase, causing a deterioration of the balance sheets of banks and other financial institutions. Furthermore, lenders will find it increasingly difficult to distinguish between good and bad risk, possibly leading them to raise finance charges and cut back on the volume of lending, perhaps to the point of "disintermediation" at which funds stop flowing through the financial system. A reduction in the flow of credit tends to further impede aggregate spending and dampens economic activity. During the Great Depression, thousands of banks failed, causing a major reduction in the flow of credit needed to support much economic activity. Deflation can be transmitted across national boundaries in order to magnify its adverse impact. This transfer is most likely to occur in a system of fixed international exchange rates, such as under the gold standard that prevailed in the 1920s and 1930s. Under that system, trade imbalances caused international gold flows—gold outflows from countries with trade deficits and gold inflows to countries with trade surpluses. Gold inflows tended to increase the surplus country's money supply and raise its price level, whereas gold outflows tended to decrease the deficit country's money supply and reduce its price level. The change in relative prices of foreign and domestic goods would then work to correct the trade imbalance and stop the flow of gold. To ensure that this adjustment was timely and orderly, central banks would intervene.