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. 

RELATED TERMS
  1. Price Inflation

    Price inflation is the increase in a collection of goods and ...
  2. Headline Inflation

    The raw inflation figure as reported through the Consumer Price ...
  3. Inflation Targeting

    Inflation targeting is a central banking policy that revolves ...
  4. Inflation Protected

    The types of investments that provide protection against inflation ...
  5. Real Interest Rate

    A real interest rate is one that has been adjusted for inflation, ...
  6. Price Level Targeting

    Price level targeting is a monetary policy framework which commits ...
Related Articles
  1. Insights

    A Primer On Inflation

    Inflation has a negative connotation, but is it all bad or does it offer some tangible benefits?
  2. Insights

    9 Common Effects of Inflation

    Is inflation ever good? If you like your job it is.
  3. Insights

    Central Banks Not Equipped for Recession: Bank of America

    As inflation rates remain benign central banks are in no position to handle another recession.
  4. Insights

    U.S. Inflation Hits Four-Year High

    Rate hikes are coming as inflation picks up.
  5. Insights

    Is U.S. Inflation on the Horizon?

    Inflation, or the general price level of all goods and services in an economy, has remained subdued in the years following the Great Recession. Given recent developments, is the U.S. on the verge ...
  6. Investing

    How S&P 500, Dow Stocks May Get Killed by Low Inflation

    Investors beware. Today's low inflation may no longer help stocks outperform
RELATED FAQS
  1. What is inflation and how should it affect my investing?

    The rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss ... Read Answer >>
  2. How does the law of supply and demand affect monetary policy in the United States?

    Learn about how the law of supply and demand affects monetary policy in the United States. Changing interest rates leads ... Read Answer >>
  3. Why Are P/E Ratios Higher When Inflation Is Low?

    P/E ratios are generally higher during times of low inflation, but why is this the case? Read Answer >>
  4. What are some examples of expansionary monetary policy?

    Learn about expansionary monetary policy and how central banks use discount rates, reserve ratios and purchases of securities ... Read Answer >>
Hot Definitions
  1. Receivables Turnover Ratio

    Receivables turnover ratio is an accounting measure used to quantify a firm's effectiveness in extending credit and in collecting ...
  2. Treasury Yield

    Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations.
  3. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  4. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  5. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  6. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
Trading Center