In the scenario of an unsterilized central bank intervention in the foreign exchange market, where the central bank sells foreign reserves, the following effects can be observed:
a. The domestic money supply shrinks.
Explanation: In an unsterilized intervention, when a central bank sells foreign currency reserves and buys its own currency, it effectively removes that domestic currency from the money supply. This action reduces the amount of domestic currency in circulation, leading to a shrinkage in the domestic money supply.
b. The domestic money supply increases.
This option is incorrect in the context of unsterilized intervention. Selling foreign reserves for domestic currency contracts, not expands, the domestic money supply.
c. Increased demand for the home currency.
This can be a side effect of such an intervention. When a central bank sells foreign reserves (usually USD or other major foreign currencies) and buys back its own currency, it indicates a demand for its currency. This action can be interpreted by the market as a signal of support or strength for the home currency, potentially increasing demand for it from other market participants.
d. Increased supply of the home currency.
This option is incorrect in the context of the described intervention. Selling foreign reserves in exchange for the domestic currency does not increase the supply of the home currency; it actually decreases it.
Therefore, the correct answer in this context is (a) The domestic money supply shrinks and potentially (c) Increased demand for the home currency, depending on market interpretation and reactions.