Final answer:
The central bank buying bonds increases the money supply, as it injects money into the banking system that can be used to support more lending. Conversely, selling bonds decreases the money supply by withdrawing money from banks' reserves.
Step-by-step explanation:
When the central bank buys bonds, this operation increases the money supply in the economy. This is because the central bank is essentially injecting money into the banking system, which can be used by individual banks to increase their lending activities or to hold as reserves. Conversely, when the central bank sells bonds, it has the opposite effect; money from the banks flows back to the central bank, thus reducing the money supply.
Let's consider the key economic concept involved: open market operations. These are actions by the central bank to buy or sell government bonds on the open market. When the central bank purchases bonds, it pays for these by creating bank reserves, which are then credited to banks' accounts at the central bank. This process results in an increase in the money supply because banks now have more reserves, which can support more lending due to the money multiplier effect. On the other hand, when the central bank sells bonds, banks pay for these bonds with their reserves, leading to a decrease in those reserves and in the overall quantity of money and loans in the economy.