1. leads to an increase in the stock of foreign exchange reserves and the nominal money supply.
2. leads to a decline in the stock of foreign exchange reserves.
3. leads to an increase in the stock of foreign exchange reserves.
4. leads to an increase in the stock of foreign exchange reserves and decline in the stock of base money. Choose the correct option.
Option 3 is the correct one. When the exchange rate is fixed, equilibrium is determined by the intersection of the IS curve and the ZZ line. The stock of foreign exchange reserves must adjust to yield a stock of money equal to the quantity demanded at the equilibrium levels of income and prices. A reduction in the domestic source component will reduce domestic residents' money holdings below the desired level and immediately lead to a sale of non-monetary assets abroad and an increase in the stock of official reserves sufficient to increase the stock of money back to the desired level and thereby avoid an appreciation of the exchange rate above its fixed par value. The money stock will thus remain unchanged.