Interest Rate Changes in Construction Activity - Essay Example

Generally the construction activity is sensitive to changes in the interest rates and business cycles in the short term and to population growth and economic advancement in the long-term. This paper intends to present a short report on the short term effects interest rate changes on the construction industry. The behaviour of any economy can be greatly influenced by the monetary policy. It is observed that decisions about official interest rates by the central banks affect economic activity and inflation through several channels which are collectively known as the Transmission Mechanism of the Monetary Policy.

According to the Bank of England Paper on the Transmission mechanisms of monetary policy; Changes in exchange rates have a direct impact on the prices of imported goods and services and an indirect impact on the prices and the competitive ability of the products which compete with the imported products/services. The change in exchange rate is likely to affect the prices of those products in the domestic market which uses imported inputs. Thus through the transmission mechanism of the monetary policy, any changes in the official interest rates affect the savings and investment behaviour of the individuals and firms and also thereby affect domestic demand and supply of production and other manufacturing sectors of the economy.

Normally following a monetary contraction in the economy, as a result of the changes in the interest rates, the construction sector reaches the trough of the cycle first, while the manufacturing sector reacts little slowly. However the manufacturing sector reacts very strongly than the construction sector.3.0 Money Supply and Construction Activity:In general construction activity is very sensitive to credit conditions. According to Goh (1998) the amount of mortgage loans has an influence on the demand for residential construction, since house purchases are financed mainly by mortgage loans from banks.

The monetary theorists are of the view that changes in money supply cause fluctuations in national outputs and because of the interdependency the disturbances in one sector will be transmitted to other sectors and markets. A review of the different channels of mechanisms reveals that credit is the primary source of money supply to the construction activity. "A restrictive credit supply leads to decreases in demand for real estate, bonds, stocks, and other assets. Since real-estate prices are sticky, ultimately the supply of credit will affect the construction industry.

" (Raymond Y.C. TSE and John Rafetry 1999)Similarly a contraction in money supply reduces bank lending to all sectors in the economy including property developers and thereby causes a decline in the industry. Any change in money supply will have its impact on the demand for