Overheating economy in China

So far we have analysed the policies to fight with recession, here it will turn back to Keynesian theories to consider an overheating situation in the economy. Overheating is the period that economic growth rate is far above the normal, which causes an expansionary gap between the natural rate of output and aggregate demand (Frank and Bernanke, 2004: 645). The causes of overheating can be either consumption-pulled or investment-pulled, both of each will push the economy into a much hot but also danger situation, considered by Begg and Fischer (2003).

An overheating situation typically results in increased inflation, which reduces the efficiency of the economy in the future (Frank and Bernanke, 2004: 646). According to Keynesian theory, when the economy faces demand-pull inflation, a contractionary fiscal policy can be implemented by either decreasing government spending or raising taxes (McConell and Brue, 2002). US government, for instance, increased tax and slowed down the government spending during the beginnings of 1990s in order to slow the rate of economic growth and keep inflation in check (Schiller, 2005).

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This contractionary fiscal policy, which appears to be reasonable in an economic model, however, might be useless in the reality. Despites the critiques of time lags and crowding-out effect mentioned previously, many economists recently argue that an overly harsh contractionary policy may cause the problems of rising unemployment rate and economic depression (Naughton, 2007: 443).

China, however, tends to combat an overheated economy by a 'soft-landing' approach, without an intense fluctuation and rapid growth in unemployment (Roach, 2006). Due to the active expansionary policy since 1998, China have been the third economic entity in the world but also suffered the problems of overheating.

As Ignatius (2004) argues, some industries have over-invested while others, such as agriculture, still have low development.

For example, the investment in the steel industry grew 96. 6 percent in 2003. In addition to the traditional way of cutting government expenditure in infrastructure, the central government also tends to adjust the economic structure by keeping down the over-investment in several industries and prompting other less-developed sectors, such as agriculture, education and social security (Xu, 2004).

This so-called 'neutral fiscal policy' seems to be successful to cool the overall economy with an objective of a gradual elimination of inflation and overall price stability (Naughton, 2007: 443). It is not easy to draw a conclusion that whether fiscal policy is successful or not to combat economic fluctuations, since both the demand-side and the supply-side theories tend to be useful to some extent but also have many shortcomings, such as time lags, expectations, and crowding-out effect.

Besides, the policymakers have to trade-off between the short-run benefits and long-run effects in order to achieve the goal of long-run economic strategy. Definitely, the real world economy is much more complicated than which are described in the economic model. Some nations, such as China, still have many problems in their less-developed market-based economics, and the use of pure fiscal policy seems to be little influential and effective in adjusting the economy in short-run.

Even in well-developed market-based economic entities, the best approach they choose is to use the combination of fiscal and monetary polices to combat the economic fluctuation and maintain the economic stability. Therefore, it is undoubted that the most appropriate way to achieve an overall economic stability is to use the combination of fiscal and monetary policy to manage the short-run fluctuation and use the supply-side policy to achieve the long-run trends.