10. Explain in words, what happens in the market for bonds when the Bank of Cana
ID: 1142841 • Letter: 1
Question
10. Explain in words, what happens in the market for bonds when the Bank of Canada decides to sell 10 more bonds -does the demand for bonds or supply of bonds change, in what direction (increases or decreases), and what is the effect on the bond price and interest rate? From the same Bank of Canada's action (selling 10 more bonds) what happens in the market for money - does the demand for money or supply of money change, in what direction (increases or decreases), and what is the effect on the interest rate?Explanation / Answer
When Bank of Canada decides to sell 10 more bonds, the supply of bonds increases in the markets. As bonds supply increases, the bond prices trend lower and the impact on interest rates is that rates trend higher.
The logic is that when Bank of Canada sells more bonds, it effectively reduces the money supply in the system and with relative tightening of liquidity, the cost of money (interest rates) trend higher.
To elaborate further, this is the policy action for easing and tightening monetary policies. When the central bank desires to incease money supply, it buys bonds and that provides liquidity to market participants. Buying bonds increases price of bonds and reduces interest rates. In the given case, selling bonds absorbs money from market participants and reduces money supply.
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