DEFINITION of 'Overheated Economy'

An overheated economy is one that has experienced a prolonged period of good economic growth and activity that has led to high levels of inflation (from increased consumer wealth). This sharp rise in prices causes inefficient supply allocations as producers overproduce and create excess production capacity in an attempt to capitalize on the high levels of wealth.

Unfortunately, these inefficiencies and inflation will eventually hinder the economy's growth and can often be a precursor to a recession.

BREAKING DOWN 'Overheated Economy'

Simply put, an overheated economy is one that is expanding at a rate that is unsustainable.

Rising rates of inflation are typically one of the first signs that an economy is overheating. As a result, governments and central banks will usually raise interest rates in an attempt to lower the amount of spending and borrowing. While central banks can combat rising inflation through interest rate increases, they can often come too late. Because inflation is a lagging indicator, it can take a while for changes in policy to reduce the rate. 

Between June 2004 and June 2006, the Federal Reserve Board increased the interest rate 17 times as a gradual means of slowing America's overheated economy. However, two years later U.S. inflation hit 5.6 percent, a cycle high. This rapid rise in prices was followed by a crippling recession, which saw inflation plunged below zero within six months. 

Another characteristic of an overheated economy is abnormally high levels of consumer confidence, which is often followed by a sharp reversal. 

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