1. an increase in the domestic stock of base money unless the central bank sells an equivalent amount of domestic bonds.
2. an increase in the domestic stock of base money no matter what else the authorities do.
3. an increase in domestic high-powered money if the central bank sterilizes its effect on reserve holdings.
4. all of the above.
Choose the correct option.
Option 1 is the correct one. By itself, an increase in the stock of foreign exchange reserves---that is, a purchase of foreign currency-denominated assets in return for domestic currency---necessarily puts high-powered money in circulation. If the central bank sells an equivalent amount of domestic-currency denominated bonds, however, it will take these funds back out of circulation. In this case it will be sterilizing the effects of the change in official reserves on the domestic monetary base. The second option is a wrong choice because it doesn't rule out sterilization.
Recall that the stock of base money is created through two avenues: a) the purchase of domestic securities by the central bank (or in some cases a switch of government deposits from the central bank to the commercial banks) and b) the purchase of foreign-currency denominated securities by the central bank. The stock of base money H thus equals
H = R + Dsc
where Dsc is the domestic source component and R , the stock of official foreign exchange reserves, is the foreign source component. Changes in R that are offset by opposite changes in Dsc will leave H unchanged.