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How the central bank can protect the economy from overheating?
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Loading...It is a well-known fact that even when the economy performs well and the rates of expansion are rising, there may be stumbling blocks. One of the central roles of the central bank is to intervene in the market when it is imperative: a lagging of the economy (which often happens) or, in a lesser case, "overheating the economy".
When can the economy overheat? We see rapid growth in all sectors, almost no unemployment, inflation is around the central bank's target, interest rates stimulate the economy enough. Everything sounds good .. why then does a problem arise?
After a certain period of normalized inflation rates and interest rates, producers in the economy adapt to economic conditions and start producing more efficiently. The problem comes when their inventories increase, which is almost always in a state of upsurge, and demand for goods remains the same. When that moment comes - of excessively high supply and production, but low or unchanged demand - the economy overheats and starts a contraction cycle. The market is flooded with goods for which there is no demand, or the goods just remains in the manufacturers' warehouses without making a profit. If this period persists long enough, manufacturers usually start to lose their job and eventually go bankrupt.
What can the central bank do?
First of all, the bank has to properly assess what opportunities are in the economy. Is there any expectation of a reduction in production without harm to the producers or is expected to increase demand and consumption. What are inflation expectations and how much interest rate is adequate to these expectations.
The strongest instrument of the central bank is the change in the base interest rate. With too much supply, the bank's most logical decision is to lower the interest rate. The interest rate cut will allow consumers to take cheaper credit and thus pour money into the economy = buying goods from manufacturers. This way, manufacturers will be able to sell their stocks and increase their cash flow, which will protect them from bankruptcy.
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