Bond market downturn - how does money supply change?

Question

When people are pessimistic with bond-holding due to the bearish bond market, chances are high that they would change the ratio of portfolio (i.e., increase the ratio of money, decrease the ratio of bonds).

In this process where money demand increases, will there be also an increase in money supply from open market operations? Is the central bank going to buy back bonds from consumers and increase money supply accordingly to meet money demand? I am confused whether OMO takes place when there is an increase in demand for liquidity preference.

Answer 1

Since OMO is a decision that the Central Bank (CB) takes, one cannot say that it will happen or not. But you have touched an important point which is often a big problem for CBs.

The extreme case of the scenario you have painted is liquidity trap. CBs, even if, inject more money into the economy chances are it will flow under the mattresses if people continue to expect increase in interest rates. This creates a trap like situation for CBs.

Would CBs still do it? Depends entirely on what they think is correct. Japan for example continued monetary easing in the face of very low interest rates (trap like situation) for years. But generally, in such situations OMO is accompanied by expansion of fiscal expenditure.