What defines an "overheating economy"?

An overheating economy is characterized by rapid economic growth that significantly outpaces the sustainable capacity of the economy, often resulting in high inflation. When an economy grows too quickly, it can lead to excessive demand for goods and services, which drives prices up as supply struggles to keep pace. This situation typically occurs when consumer confidence is high, businesses invest heavily, and employment levels rise leading to increased consumer spending.

In this context, central banks may intervene by raising interest rates to cool down the economy, as unchecked inflation can erode purchasing power and destabilize the economic environment. Recognizing these dynamics helps to understand the balance that policymakers must maintain between fostering growth and controlling inflation.