Detailed Explanation:

Answer: Option 1 — Conducting 'Open Market Operations'

Sterilization is a monetary policy tool used by the Reserve Bank of India to neutralize the impact of foreign exchange interventions on domestic money supply. When the RBI buys foreign currency to prevent rupee appreciation, it injects rupees into the system; to sterilize this liquidity surge, the RBI conducts Open Market Operations (OMO) by selling government securities, thereby absorbing the excess money. This process prevents unwanted inflationary pressures and maintains monetary stability while managing the exchange rate.

📝 Short Notes: Sterilization and Monetary Policy Tools

• Sterilization: Process of offsetting the effect of foreign exchange interventions on domestic money supply through counter-balancing monetary operations.
• Open Market Operations (OMO): Buying or selling of government securities by the central bank in the open market to regulate money supply and liquidity.
• Mechanism: When RBI buys foreign currency → Rupees injected → RBI sells bonds (OMO) → Rupees absorbed → Net effect neutralized.
• Objective: Maintain exchange rate stability without affecting domestic liquidity conditions and inflation.
• Tools Used: Primarily government securities (G-Secs), treasury bills, and other eligible instruments.
• Context: Particularly important during periods of large capital inflows or outflows to prevent exchange rate volatility while maintaining monetary policy independence.