What is hyperinflation?

Definition and Examples of an Overheated Economy

An overheated economy is when the economy grows too quickly. An overheated economy reaches the limits of its output capacity to meet the demand from consumers and businesses, where there are very few underutilized resources.

An overheated economy is one that produces above its potential output or above the natural rate of unemployment (NRU). Both can occur when the economy grows too quickly.

Potential output is the output that an economy can sustainably produce based on the available quantity of resources such as labor, technology, and equipment. The NRU is the lowest level of unemployment that the economy can achieve without causing inflation. This is also known as “full employment” and is considered to be between 4% and 6% in the United States. An overheated economy is one that grows at a rate that exceeds a sustainable rate.

The problem with an overheated economy is that supply cannot meet the demand for goods. This can lead to a rapid increase in prices, and then companies may offer higher wages to attract workers, further increasing prices. If the overall price level rises high enough, it creates inflation, which can suppress economic growth.

An example of an overheated economy is the period surrounding the financial crisis between 2007 and 2009. Prices surged quickly in the United States, with annual inflation at 2.9% in 2007 and 3.8% in 2008, which was higher than the inflation target set by the central bank at 2%. The unemployment rate was 4.6% in 2007, which was also at the low end of (or below) the NRU. The unemployment rate eventually rose to 5.8% in 2008 and over 9% in 2009 and 2010, and inflation fell back below 2%.

How Does an Overheated Economy Work?

Typical signs that an economy may be overheating include rising wages and prices due to increased lending. If interest rates are low for an extended period, consumers and businesses may borrow to spend on goods and investments. The increased demand for consumer goods and assets leads to rising prices. Rising asset prices encourage more borrowing as people feel wealthier, creating a feedback loop that can generate an asset bubble.

Asset bubbles may occur when the economy is overheating. An asset bubble is when the price of an asset rises, but the increase in price is not attributable to an increase in the underlying value of the asset.

For example, the low interest rates that preceded the financial crisis in the United States between 2007 and 2009 contributed to an overheated economy as more people borrowed money to buy real estate (due to low borrowing costs). Real estate prices began to rise, leading to the creation of an asset bubble – also known as a housing bubble.

When an asset bubble bursts, asset prices collapse, and lenders will cut back on the amount of credit they allow people to borrow. Ultimately, the housing bubble burst, and by 2012, many cities saw declines in home prices. From 2006 to 2012, home prices dropped by 62% in Las Vegas, 54% in Phoenix, and 50% in Miami. This type of situation not only harms banks that have not recouped the mortgage loans they provided, but it also hurts the economy as a whole as lending and investment decline.

How to Cool an Overheated Economy?

One way to cool an overheated economy is to use a tight monetary policy. A tight monetary policy aims to slow down inflation and make borrowing more expensive for consumers and businesses. This will reduce demand for consumer goods and assets.

Example

The tight monetary policy involves raising interest rates. For example, the American central bank (the Federal Reserve) can raise the federal funds rate; this affects other interest rates in the economy, such as mortgage rates and bank loans, to help make borrowing more expensive for consumers and businesses. This can help cool down an overheating economy.

Is the American economy overheating?

The COVID-19 pandemic caused global human and economic difficulties. The Federal Reserve took several measures, including lowering interest rates, stabilizing financial markets, starting a corporate bond purchase program, and the Paycheck Protection Program liquidity program, aimed at helping businesses obtain liquidity or cash.

Once the economy recovered and the unemployment rate decreased, prices began to rise. While the Federal Reserve asserted that the American economy is not overheating and that inflation is temporary in 2021, there were signs that the economy was starting to overheat.

In a report issued by the Federal Reserve on July 9, 2021, the Federal Reserve showed an increase in demand for goods and a decrease in supply due to material shortages and labor shortages. As a result, prices began to rise, and by fall, inflation was at its highest level since June 1982.

In November 2021, inflation reached 6.8%, and the unemployment rate was 4.2%. Global demand also increased in 2021 due to multiple stimulus measures and low interest rates. This drove the prices of many consumer goods and assets even higher. In response to the added wealth of companies, workers’ wages increased. Workers had more money to spend by the end of 2021, and demand was further stimulated. Additionally, there were, and still are, supply chain disruptions due to labor and raw material shortages, leading to rising prices and contributing to inflation. All of these were contributing factors to the rapid rise in prices in 2021 – a typical hallmark of an overheating economy.

In December 2021, the Federal Reserve issued a statement acknowledging the imbalance between supply and demand. While keeping the federal funds rate low between 0% and 0.25%, it assured that it was prepared to change those rates when the labor market reached levels consistent with optimal employment.

By March 2022, the unemployment rate reached 3.6%, and inflation rose to 8.5%, far exceeding the natural rate of inflation of 1% to 2% for the United States. The Federal Reserve had to reverse course, and in March, it began tightening monetary conditions by raising interest rates and accelerating the end of the Federal Reserve’s bond purchase program. These actions aim to slow down the economy and reduce inflation.

Sources

The Balance used only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.

Federal Reserve Bank of San Francisco. “The Natural Rate of Unemployment Over the Past 100 Years”.

Federal Reserve Bank of Minneapolis. “Consumer Price Index, 1913 -”.

Bureau of Labor Statistics. “Labor Force Statistics from the Current Population Survey”. Output “2007” to “2010”.

Federal Reserve Bank of St. Louis. “Recovery and Collapse of Real Estate Prices in the U.S. from Different Geographic Perspectives”.

Federal Reserve Bank of St. Louis. “How the Federal Reserve Responded to the COVID-19 Pandemic”.

Bureau of Labor Statistics. “Consumer Price Index Summary”.

Bureau of Labor Statistics. “Employment Situation – November 2021”.

Board of Governors of the Federal Reserve System. “Federal Reserve Statement on December 15, 2021”.

Bureau

Labor statistics in the United States. “Consumer Price Index – March 2022.”

U.S. Bureau of Labor Statistics. “Labor Force Statistics from the Current Population Survey.”

The Federal Reserve. “Implementation Memorandum issued on March 16, 2022.”

Source: https://www.thebalancemoney.com/overheated-economy-5214761