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The inter-relationship between the health of the economy and interest rates is an incredibly important and often discussed topic. And recently in Australia the link between these and the housing sector has been heavily scrutinised. Penm et al. (14, p. 41) have even suggested �housing activity is a leading indicator of general economic activity”. In the Australian economy, the housing market is booming, some believe out of control. Whether or not the boom is sustainable is a topic which has serious consequences for the growth or contraction of the economy, and where opinions differ wildly.

The housing market has been experiencing a new high recently. Lenders lent a record $ billion in March to people buying, building or refinancing their homes (Colebatch 00). This increase in demand for housing has pushed up the cost for some first homebuyers to a prohibitive level. The prices for housing are experiencing 0 per cent to 5 per cent annual growth (Dempster 00). This likely to be the effect of a shift in demand for housing and building, exceeding any shift made to supply in response. As the diagram (Pindyck & Rubinfeld 001, p. 6) shows, the shift of the aggregate demand curve from D1 to D outweighs the shift in supply made in response (S1 to S). This results in increased quantity (Q1 to Q), but also increased price (P1 to P).

Quantity demanded has increased over a large number of housing markets at once because this is a �hot” period for residential real estate markets (which experience �hot” and �cold” periods). A hot period is one where �average selling times are short, the volume of transactions is higher than the norm and prices are rising’ (Krainer 1, p.14). Many are predicting that this demand will not last and that �the residential construction boom is likely to peter out”(Statistics of Australia’s Economy 1-004 00). At these prices, first home buyers account for just over 15 per cent of loans for the year to March, which is close to an all-time low (Colebatch 00). Also, there is oversupply in some areas, especially high-density unit markets in Sydney and Melbourne (Wade 00). This is because oversupply leads to a reduction in prices, since there are more providers on the market (S1 to S) without corresponding demand. The competition for buyers sends the prices down (P1 to P).

But a review of the building industry, conducted by Robert Meller and Jason Tyrrell of

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BIS-Shrapnel, has predicted demand in the building industry will be sustained (Wade 00), as well as suggesting interest rates on home loans could reach 10% by 006 (Teese 00, p. 6). While the authors of the review concede, There is now substantial risk that the looming oversupply will see a sharp and protracted correction” (What is the housing market doing? 00), they feel the oversupply and soaring prices will result only in a lull over this year. Both residential and non-residential building commencements will move into a fully fledged boom over the two years to 005-06, driven by strong economic growth, as well as increasing underlying demand in both sectors, the report says.

The rationale behind this is that the Australian economy is growing out of the trough in the business cycle it experienced in 000-001. It is expected to grow in 004 along with an anticipated global recovery and increased output from farms (Statistics of Australia’s Economy 1-004 00). BIS Shrapnels forecast is for strong economic growth over the next three years, sending the unemployment rate below 5 per cent. �This will create labour shortages that will push wages higher and increase inflation. In turn, the Reserve will jack up interest rates aggressively”, the report says. Here, the relationship between the state of the economy and interest rates is expressed explicitly.

The effect of a recovering economy will be both workers and producers will expect aggregate demand to increase, triggering an increase in prices. To maintain the same real wage level, workers demand wage increases, changing aggregate supply. This results in the price level rising again in the next period. This is a continuing positive rate of inflation (Crompton et al. 00, p. 74-75).

At point A, workers and firms expect the price level to be 100, shown in the supply curve SRAS100. Workers and firms expect aggregate demand to shift to D, making the price level 1. Workers then demand wage increases to maintain their real wage, shifting aggregate supply to SRAS1. The price level rises again in the next period, resulting in an ongoing inflation rate (Crompton et al. 00, p. 74).

The Reserve Bank of Australia aims to keep the inflation rate of the economy within two to three per cent. The BIS-Shrapnel review proposes that in the middle of 006 inflation will need to be controlled, as it gets too high. One of the methods of controlling inflation available to the Reserve Bank of Australia is to increase interest rates. Because interest rate increases making borrowing money more expensive, the measure lessens spending in the economy. This acts to limit the increase of aggregate demand in the economy. As Alan Thornhill (00, p. 17) says �household consumption could retreat quite quickly”.

Interest rate rises do reduce the rate of inflation, but with a reduction in demand comes a reduction in output, and so increased unemployment as production is cut and workers are no longer needed. If the economy slows and you get rising unemployment, many people will have great difficulty servicing mortgages,” the review says (Wade 00).

The review predicts that at 10% interest rate level, the level of new building will fall 0% in the two years between 005-006 and 007-008 (Wade 00). Demand for building decreases when interest rates rise for several reasons. Firstly, the cost of borrowing money increases, so buying or building a house is less affordable. Also, businesses are producing less after the rate rise, so there is less of a need to purchase plant and capital, including buildings. So, the relationship here between interest rates and investment, including housing, is obvious.

This diagram shows the effect of raising interest rates on the economy. Workers and firms expect aggregate demand to increase to D. They negotiate increased wages, which shift aggregate supply to SRAS140, based on this. But the price rise that results is higher than the Reserve Bank of Australia’s target. So, the RBA increases interest rates, moving aggregate demand back to D (Crompton et al. 00, p. 76). The price level is reduced, but so is output, and unemployment increases.

With fewer employment opportunities in the community and home buyers with variable interest loans paying higher interest there is �some severe pain” to be �felt in the community” (Wade 00).

It is obvious how inter-dependent the state of the economy, interest rates and the housing market are. The level of activity in the economy, or even the performance of one sector such as housing, are leading factors in any change of interest rates by the Reserve Bank of Australia. Any changes in interest rates can act to inflate of deflate the economy, and also an individual sector like housing. And deflation of an important sector such as housing can be the cause of �significant general economic fallout” (Thornhill 00, p. 17). It is also now obvious why the state of the housing market, or any attempts to influence the economy through monetary or fiscal policy, are so keenly watched and debated.

Reference List

Colebatch, T. 00, Housing boom continues [Online], The Age, Available http//www.theage.com.au/articles/00/05/1/1055178461.html [00, Oct. 1].

Crompton, P., Swann, M., Hopkins, S. & McEachern, W. 00, Macroeconomics, Nelson Australia Pty Ltd., Southbank Victoria, p. 68-86.

Dempster, Q., O’neall, I., Cole, B., Triglone, T., Jenman, N., Shann, E. & Mellor, R. 00, Australian Broadcasting Corporation Lateline TV Program Transcript [Online], Available http//www.abc.net.au/lateline/s50110.htm [00, Oct. 1].

Krainer, J. 1, Real estate liquidity, Economic Review - Federal Reserve Bank of San Francisco, vol. , p. 14-7.

Penm, J. & Terrell, R. 14, Is housing activity a leading indicator?, Economic Record, vol. 70, issue. 10, p. 41-5.

Pindyck, R. & Rubinfeld, D. 001, Microeconomics, 5th Ed., Prentice Hall International Inc., New Jersey, p. 0-58.

Statistics of Australia’s Economy 1-004 00 [Online], Available http//www.oecd.org/dataoecd/5/10/74675.pdf [00, Oct. 1].

Teese, C. 00, ‘Home rates could hit 10pc expert’, The West Australian, 6 Aug., p. 6.

Thornhill, A. 00, ‘Bank warns on family debt’, The West Australian, 1 Sept, p. 17.

Wade, M. 00, Life in housing boom still [Online], Sydney Morning Herald, Available http//www.smh.com.au/articles/00/08/5/10616675507.html?from=storyrhs [00, Oct. 1].

What is the housing market doing? 00 [Online], Available http//finance.ninemsn.com.au/money/Property/stories/education_1.asp?MSID=16d7c58f77b14bb7baec4e7cd74d46e [00, Oct. 1].

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