What it means to have an Overheated Economy

What does it mean to have an overheated economy?

Isn’t economic growth a good thing? How can there be “too much” growth?

To understand the answer, we’ll first have to understand the business cycle.

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The Business Cycle

The business cycle is is a term used to describe the alternating periods of economic growth and contraction.

In an ideal world, economic growth would be stable and there would be no periods of contraction.

In the real world however, people tend to either over-estimate or under-estimate their business projections, which leads to an inefficient allocation of economic resources.

Over time, these imbalances in the economy accumulate and result in the business boom and bust cycle.

On average, the duration of each boom-bust cycle is 7 years.

How An Economy Overheats

At the end of every recession, businesses are still feeling the negative effects of the slowdown, so they tend not to invest in new projects or hire new staff.

With few job openings and with workers afraid of getting laid off, people generally buy fewer things which leads to continued slow economic growth.

Over time though, people stop being pessimistic about the future and begin to feel comfortable with spending again. As they buy more things, businesses make more profits and begin to expect further business growth down the road.

To prepare for this growth, business managers order more inventory from suppliers and invest in new machines and factories. This means that more staff is required and so more people are hired to run these machines and factories.

how an economy overheats

With more jobs now available, and with people getting pay raises, the future slowly starts to look optimistic again. Thus, people become more willing spend on products and services which further increases companies’ profits.

This self-reinforcing cycle results in an economy that grows exponentially.

Now since the ability to produce goods and services is slower than the ability to buy them, consumer demand eventually exceeds producer supply. This simply means that people want to buy more stuff, than there is stuff to sell to them.

And what happens when supply goes down and demand goes up?

That’s right, prices go up!

The result is thus the general increase of product and service prices, which we call inflation.

The higher inflation goes, the more unaffordable things become, and the higher the likelihood of an economic crash. This is the situation in which people refer to as an overheated economy.

Signs Of An Overheating Economy

As people feel richer, they tend to invest more in the stock market and buy bigger homes, driving the prices of these assets up. Since people are increasingly optimistic about the future, they also spend more on luxuries and save less.

But a growing economy doesn’t just affect the local population. Overseas investors also want a piece of the action and look to invest in the country. In order to do this, they have to exchange their currency for the local currency, thereby pushing its value up.

And what about local businesses? Well, they’ve been seeing an increasing demand for their goods and services, and are more than happy to take on more credit to grow their operations. If people are buying up your products, it makes sense to build more factories to produce and sell more of those products!

Now as companies take on more loans (and later pay them back plus interest), banks get richer and are more willing to provide even more credit to businesses at lower interest rates.

In this manner, an overheating economy is characterised by:

  • high inflation levels
  • high asset prices
  • a low savings rate
  • an appreciating currency
  • high levels of credit
  • low interest rates

As an economic boom enters its final stages, people begin over-estimating the potential for further growth.

Businesses start producing more frivolous goods and services, and people are so full of debt that they start struggling to pay them back.

If this trend continues, both businesses and consumers won’t be able to pay back their loans, which would lead to a string of bankruptcies that can crash an economy.

Thus, economists will want to slow growth down before things get too bad.

So you see, growth by itself isn't bad. It's unsustainable growth that's bad.

How Economists Handle An Overheated Economy

If people (and companies) only spent they had, the economy wouldn’t overheat because people would naturally stop spending when they run out of money.

With credit however, people (and companies) can keep spending as long as the banks are willing to give them a loan.

how economists handle an overheated economy

A key to slowing down the economy is thus to increase the cost of loans. This means increasing the loan interest rate.

With a higher interest rate, people are discouraged from getting loans. After all, a couple looking to buy a million dollar house is likely to think twice if the interest on their mortgage is 10%.

Thus, one of the first things a central bank will do to slow down an overheating economy is to raise interest rates.

Another thing the central bank can do is to reduce the money supply by issuing bonds (i.e. borrow money), which reduces the availability of cash and credit in the economy.

By taking money out of the economic system, there is less cash being spent on goods and services, which works to reduce inflation.

These two channels of regulating interest rates and money supply is what people refer to as monetary policy.

The job of the central bank is thus to ensure stable economic growth with an appropriate monetary policy.

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