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What is Overheating?
What does overheating mean?
Overheating refers to a situation where an economy is growing close to its potential growth with the resources at its disposal, but this rate of growth is not enough to meet the demand. In other words, the productive capacity of the economy is unable to keep pace with the aggregate demand. The demand is usually stoked by expansionary monetary and fiscal policies.
What are the signs?
The first sign of overheating is usually a fast rise in prices. An economy growing above its potential rate may not find enough inputs to meet the demand, leading to an increase in prices. But more than a generalised rise in prices, it is the rise in wages that is a better indicator of overheating. Stretched physical infrastructure such as heavy demand for electricity, transport and ports also indicate overheating. High credit growth and rapid rise in asset prices are other signs.
How can it be checked?
Since overheating refers to a situation of an economy growing above a sustainable rate, bringing the growth down a bit should cool things. This is usually done through monetary and fiscal tightening. The government tries to reduce expenditure while the monetary authorities raise interest rates to curb credit growth.
In specific situations of asset bubbles, curbs on lending to some sectors could also be imposed. These measures usually help curb demand and slow down the economy.
What are the consequences?
If overheating goes unchecked, growth could rise in the short term, leading to a hard landing later. This could depress growth till the time excesses are removed. High inflation would tend to discourage investments and create uncertainty. System could be saddled with excess capacity to meet the spike in demand. The banking system could be saddled with non-performing loans when asset bubbles burst. Excess borrowing by consumers could depress spending for a long period.
(Updated - 15 April 2011)
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