Explainer - What does overheating in the economy mean?

What does overheating in the economy mean?

A strong and growing economy is good for consumers, businesses and society as a whole. When the economy is growing, more people are likely to be in work, earning their own money and improving their standard of living.

Can the economy grow too fast?

A fast-growing economy is desirable so long as that growth rate is sustainable. However sometimes the economy can grow too fast. In economics this is called "overheating". Overheating is when the economy reaches the limits of its capacity to meet all of the demand from individuals, firms and government. One element of this is the concept of "full employment", which occurs when almost everyone who wants to work has a job. When this happens, there is very little available slack. In other words, the amount of unused resources, or spare capacity in the economy - is very limited or non-existent.

Why should we care about overheating?

The problem with overheating is that it tends to result in a harmful downturn. When the economy overheats some producers are not able to supply all the goods that consumers demand. This can lead to prices rising faster than they otherwise would. This in turn can cause a "wage-price spiral" to develop, where higher prices lead to higher wages and vice versa. Wage-price spirals are more likely to occur when an economy is close to full employment, because employers need to offer higher wages in order to attract new workers or retain existing workers.

Exporters find it more difficult to sell their goods abroad due to higher costs and prices. Households and firms could also increasingly turn to imports to meet their demands. Before long, rapidly increasing prices can become a major problem. For example, rapid price rises can erode Ireland's competitiveness, lead to a reduction in trade and job losses.

Overheating can also make households and firms over-optimistic about their future income prospects, and lead them to take on too much debt. If this future income fails to materialise, adjusting to a sustainable growth path can be painful. The result can be bankruptcies, job losses, wage reductions and cuts to public services.

What can indicate if the economy is overheating?

There are number of signals that can indicate if the economy is overheating. One indicator involves comparing current levels of actual economic output with estimates of potential output. Potential output measures what the economy can sustainably produce given the available resources (workers, equipment, technology and infrastructure). If actual output is above potential output this could give rise to overheating.

Other indicators of overheating are wage and price pressures, or large increases in lending. An increasing reliance on imports to meet demand could also be a sign of overheating.

When assessing overheating risks in the labour market, economists pay particularly close attention to unemployment and job vacancies. When there are many jobseekers who cannot find work, there should be less concern about overheating.

Too much borrowing can be both a source and sign of overheating. This can lead to asset bubbles, notably in housing markets, but also stock markets. Asset bubbles make households feel wealthier and consumption rises above sustainable levels.

What can policymakers do to avoid overheating?

Preventing excessive lending and creating buffers to absorb shocks when they occur is one way of cooling an overheating economy. To achieve this objective, the Central Bank uses macro-prudential policies.

For example, since 2015, we have used the Mortgage Measures. These are designed to ensure that banks and other lenders lend sensibly and also protect house buyers from borrowing more than they can afford. More recently, we have activated the Countercyclical Capital Buffer. Its aim is to build resilience in the banking system and protect against a future downturn.

Another way to cool economic growth is to increase interest rates (monetary policy). This reduces the level of demand in the economy because higher interest rates encourage households and firms to save more, and spend less. Our interest rates are set for the euro area as a whole so may have a limited role to play when the overheating is driven by domestic, rather than external, demand.

Finally, government decisions on expenditure and taxation (fiscal policy) should be careful not to add to demand when the economy is at, or nearing, full capacity. For example, it can reduce expenditure (or increase taxes) to reduce demand in the economy. The money it saves from such a policy could then be put aside for use at a time when demand in the economy is weaker.

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