Question

What is an overheating economy? What causes it? Draw a graph to help illustrate your answer

Answer 1

"An overheating economy can be defined as that which is experiencing a prolonged period of economic growth that led to high level of inflation."

Inflationary rate is high because the consumers are having large amount of surplus fund available with them. The economic growth causes larger inflow of cash into the economy which in turn increases the aggregate demand of the consumers. In anticipation with the increase in demand the suppliers also produce surplus output by creating or expanding the production facility.

The rising level of inflation is this sign that economy is overheating. This the government and the central bank always attempt to keep the inflationary rate under control (through its monetary policy) otherwise the higher inflationary rate may be a cause of recession.

Refer to the picture above. We can see the Aggeregate demand curve is increasing with the increase in employment level. The economy start to overheat when the employment level is 100%. That is due to prolonged economic growth the suppliers have expanded their production facility hence the employment level is at 100%. Thus, the surplus fund available with the consumers will be high which will directly increase the inflation. This, is an example of overheating economy.

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