Relationship between bond prices and the market rate of interest

Face value          I.R             Current rate      Market price
                                                                       
£100                         £5                    5%                     £100
£100                         £5                   4%                      £125
£100                         £5               10%                         £50

therefore a rise in interest rates leads to a fall in the value of bonds because you still only get £5 but you could get a higher rate of return from other saving accounts

 

Creation of credit

Assume: banks have deposits and advances

  • Liquidity ratio of 10% – this is with the BoE and its purpose is to provide sufficient liquidity
  • If banks initially have £100 bil. Then they will hold £10 bil, and advance £90bil
  • If the gov’t spends an extra £10 bil then this will eventually be deposited in banks. But this gives the banks surplus liquidity, 20/110.
  • Therefore to maintain a liquidity ratio of 10% they can advance £9 bil. to consumers.
  • But this £9 billion will be spent and it will eventually be deposited in banks by shopkeepers, therefore the banks will again have surplus liquidity, therefore the banks need to keep only 10% of this so another 8.1bil will be advance
  • An initial increase in balances with the bank of England will lead to a total increase of £90 billion making a total increase of £100 bil
  • This effect is known as the bank or deposits multiplier
  • Bank multiplier =  1/ L

 

Creation of credit in the real world
In practice it is not as simple as this

  1. customers may not take the credit
  2. some of the cash may be withdrawn
  3. banks may not keep the same liquidity ratio
  4. Banks do not operate a simple liquidity ratio because they have a weak dividing line between near money and non liquid assets e.g. gilts, money at call, bills of exchange

 

Money Multiplier

      When there is an inflow of money into the banking system some of the cash leaks out of the banking system. This will result in an overall smaller multiplier rise than the full banking multiplier. This overall multiplier is known as the money Multiplier.

MM is the number of times greater the expansion of the money supply following an expansion in the monetary base that caused it.

Change Ms/ Change Mb

more on relationship between bond price and interest rate