Case Application: The Interest Rate 1981 more than 2,000 construction firms went

Question

Case Application: The Interest Rate 1981 more than 2,000 construction firms went out of business. They went broke because housing construction fell to the lowest level in years, with hundreds of thousands of construction workers not of a job. The National Association of Realtors lost 70,000 members between 1978 and 1981. Other industries also had high mortality rates. In 21/2 years some 2.600 automobile dealerships closed their doors. There was a 41% jump in business failures in 1981 as small businesses and farmers suffered foreclosures. This havoc in the business world was not caused by a major depression but rather by sky-high interest rates-rates as high as 23% for construction loans alone. Potential housing buyers were unable or unwilling to take out mortgage loans at interest rates of 16% or 17%. Consequently, many construction firms were forced into bankruptcy by the banks that underwrote their construction loans. New car dealers were in the same sort of bind, often paying $142 a month in interest costs on every $10,000 automobile they had in inventory. With new car sales moving so slowly, the interest costs simply became more than many dealers could handle. It was previously unheard of for established businesses with excellent credit ratings to pay a prime rate over 20%. as they did for a short time in 1981.

Explanation / Answer

1.

Open market operation is a tool by that, Federal Reserve buys and sells treasury securities in the market. It is used as a tool to implement the monetary policy in the economy. Here, Federal Reserve sells treasury securities in the market and money is sucked out of the banks and other lenders. It causes less money available with the bank for disbursement. It causes interest rates to go on higher side that is borne by the businesses.

2.

Wide fluctuations in interest rate results in following consequences:

3.

Objective of controlling money supply is to control the inflation and reduce the ugly buying behaviour. It will also cause the bank to verify borrowers before lending. Though, improper implementation of contractionary monetary policy as well as loopholes in regulation and interest rates are increased by banks themselves is causing such problems. Thus, it is not the objective but the implementation that is cause this problem.

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