Overheated Economy

Updated on January 31, 2024
Article byGayatri Ailani
Reviewed byDheeraj Vaidya, CFA, FRM

What Is An Overheated Economy?

An overheated economy is a situation in which the economy grows exponentially with an output greater than the normal level and exhibits full employment. It harms the nation because it causes a spiraling wage-price system and unexpected inflationary pressures.

Overheated Economy

The primary cause of overheating is the high total demand for all finished goods and services produced in an economy. Unsustainable production techniques, such as resource overuse, increase output to satisfy the increasing demand. The unsustainability level rises when growing costs, prices, and wages are combined. Continuous infrastructure expansion to remove barriers helps avoid overheating.

Key Takeaways

  • Overheated economy definition portrays it as an economic condition that produces more than its potential production and showcases full employment. It demonstrates that the economy is growing exponentially.
  • An overheated economy results from excessive economic growth. It is also a scenario in which the supply is inadequate to meet the demand. It is followed by increases in prices and wages and rising inflation affecting economic growth.
  • The government and central bank can implement tightening monetary policies to reduce the flow of money in the economy, making borrowing expensive and people tend to save more. 

Overheated Economy Explained

An overheated economy happens when economic activities reach an excessive point too fast. In other words, there is excessive economic growth. The growth is too fast but unsustainable. The GDP growth rate of an overheating economy is higher than the normal rate. The phenomenon is usually detected during the boom phase of the economic cycle. The full capacity is being utilized, and the unused resources are scarce. Soon the producers face difficulty producing enough goods or services to the demand level. 

Prices rise, wages increase, and the country’s economy suffers from high inflation. Exporters’ revenue decreases due to high costs and increased prices. In an overheated economy, the government tries to intervene with restrictive monetary policies such as increased interest rates. Inflation reduces purchasing power, and reduced consumption can result in a harmful downturn. A decrease in overall demand, reduction in consumption, high-interest rates, and a housing bubble or asset bubble burst can result in an economic recession.

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Causes of Overheated Economy

The important causes are as follows: 

  • Ultra-loose monetary policy, low-interest rate & rising Inflation – Low-interest rates are intended to promote economic growth. These low-interest rates stimulate spending and inflation in an overheated economy. Consumer demand will increase, and businesses will spend more, driving up GDP growth and employment generation. It causes firms and investors to be overconfident. Firms produce more to sell more at the high prices prevailing in the market. In essence, if interest rates have been intentionally kept low for an extended time, there is a risk of overheating.
  • Excess money supply, economic activities, or excessive expansion – These increase the chances of high inflation. Housing prices also indicate an economy’s underlying condition. When there is an excess of money in the economy, people seek to invest it in fixed assets such as houses. The housing market overheats when the money supply is artificially increased over time.
  • Full employment: Full employment or decreasing rate of unemployment points to an increase in the people’s spending power. In other words, everyone has a job that increases the demand and spending power in the economy, which in turn has the potential to cause inflation. When a full employment situation leads to inflation in the economy, the central authority intervenes to control the money supply by increasing the interest rates.

Example

Let us look at an example to understand the concept better: 

Large oil price shocks in the 1970s resulted in huge account surpluses among oil-exporting countries and current account deficits in numerous Latin American countries. In addition, large US banks acted as intermediaries, allowing oil-exporting countries to keep their funds liquid while lending them (in US dollars) to Latin America.

Beginning from a position of already-high resource utilization, real GDP growth in the United States during the overheated period of 1978–1980 averaged roughly 21/2 percent, and the unemployment rate dropped below 6 percent. As a result, Mexico could not service its outstanding debt to the U.S. commercial banks and other creditors in 1982, as interest rates were aggressively raised to combat inflation, signaling the start of the Latin American Debt Crisis. In addition, many Latin American governments rescheduled their public debt commitments, putting pressure on some of the country’s top banks.

How To Correct It?

In booming situations, central banks use contractionary monetary policy measures to keep things from getting out of hand. The most common contractionary monetary policy instruments include raising interest rates, increasing reserve requirements, and selling government securities. 

Controlling excess lending and creating buffers to absorb shocks are two ways to cool an overheating economy. Furthermore, rising interest rates encourage consumers to save more, which helps them reduce their consumption. Furthermore, tax rates in the economy could be raised to restrict the amount of disposable money available to the populace. These policies ultimately reduce aggregate demand, lowering prices and economic output levels.

Frequently Asked Questions (FAQs)

What is the meaning of overheating in economics?

In economics, it is defined as a state of full employment, and the economic output is above the normal level. In such a state, the demand crosses the supply. As a result, supply is inadequate, and prices and wages rise, leading to inflation.

Why is an overheating economy bad?

It is bad because when the economy is overheating, supply cannot keep up with demand, leading to quick price increases, after which firms have to offer greater wages to retain workers, raising prices. Altogether contributing to inflation and unsustainable economic growth.

How to correct an overheated economy?

One method to correct this is to prevent excessive lending and build buffers to absorb shocks. In addition, the government can implement restrictive monetary policies to control inflation and reduce the money flow. For example, implementing high-interest rates encourage businesses and individuals to save more and spend less, lowering the level of demand in the economy.

This article has been a guide to What is Overheated Economy and its meaning. Here, we explain its causes, examples, and how to correct them. You can also go through our recommended articles on corporate finance –