An overheated economy is expanding at an unsustainable rate. It represents a situation where the total demand for goods and services in an economy outpaces significantly the supply. Overheating exhibits difficulty in meeting high levels of output, ballooning price and wage inflation, and full employment (when everyone wants a job and has a job). It refers to a scenario where the amount of unused resources or spare capacity in the economy is either limited or negligible.
It describes a situation where an economy is operating beyond potential productive capacity, meaning that supply is falling short of meeting the demand owing to a lack of available resources such as labor and capital.
There are two main signs of an overheating economy—rising rates of inflation and an unemployment rate which is below the normal rate for an economy.
Causes of an Overheating Economy
The two main signs of an overheated economy are – increasing inflation rates and a scenario of near-full employment. Other causes may include asset bubbles and external economic shocks.
Asset bubbles refer to an unsustainable escalation in the market value of certain assets, way above their intrinsic value. An example of this could be the bursting of the dot-com bubble 2001, resulting in a recession.
Challenges with an overheated economy:
Overheating of an economy can pose multiple issues:
1) Costlier Goods & Services:
The manufacturers or suppliers would pass on the additional costs to the customers. Ultimately, prices of goods and services can significantly rise because of high levels of demand.
2) Higher Wage Costs:
To meet the higher level of demand, the employers would employ more workers to expand the production capacity. The employer is likely to incur more expense in hiring a worker as in the scenario of low unemployment, employers would need to offer competitive wages to attract applicants or retain existing workers.
3) Higher Inflation:
A scenario of lower unemployment and increased wages would boost the propensity to spend off the customers, hence fueling the demand side. This is called a wage-price spiral.
The wage-price spiral is a macroeconomic concept that shows the correlation between the increased disposable income of consumers and the prices of goods and/or services.
4) Increasing Debts:
In a scenario of lower unemployment and higher wages, people can be over-optimistic about an incremental change in their wages in the future. It may cause them to take large levels of debt. However, if wage growth is tepid or insignificant, it can discourage people from paying off their debts, destabilizing the financial fulcrum of the economy.
It may also lead to bankruptcies, job losses, wage reductions, and cuts to public services.
5) Fall in Exports:
With the increase in prices of domestic products, foreign consumers would be discouraged from purchasing these goods. Similarly, domestic consumers will now have the option to purchase foreign goods at a relatively cheaper cost. Foreign goods would be preferred over domestic goods. Therefore, national imports will leave behind the exports, causing a negative change in the balance of trade.
Managing Overheating:
Policymakers should try to counter the ill effects of overheating, taming the economy if it is growing unsustainably exponentially. This can be done using two policy tools available: monetary policy and fiscal policy.
Central banks control the monetary policy. They manage the money supply in an economy by finalizing interest rates and targeting inflation and unemployment.
The government makes the fiscal policies and decides on taxation slabs. The pace of economic growth can be decelerated by increasing taxation and lowering spending, resulting in taking money out of the economy (i.e. contractionary fiscal policy). Vice-versa, decreasing tax slabs and increasing spending would inject more money into the economy.
A contractionary policy is a fiscal policy focusing on slowing down the economy.