Do bond prices increase due to increase in demand or increase in money supply?

Question

When the Fed buys bonds, what will happen to the price of bonds in the open market?

Answer Key: Reward 1 point for stating the price will increase due to increase in money supply. (0 point is awarded otherwise)

I could answer that the price of bonds will increase, but my explanation is this:

When the Federal Reserve purchases bonds, the price of bonds will go up. This is because the demand for bonds has increased, which increase bond prices.

Both explanations seem valid to me.

Can someone please explain why my answer is incorrect?

Thanks

Answer 1

Nothing is wrong with your explanation. Indeed it’s the increase in demand that for bonds that increases their price.

Increase in money supply can increase demand for bonds, so it’s not wrong to say that increase in money supply causes bond prices to increase either. This is because bond prices are inversely related to interest rate and increase in money supply lowers the interest rate, as bonds are fixed income securities so if regular interest rate falls they become more attractive to hold ceteris paribus.