may have material implications for cross - border spillovers - - an important issue that until very recently had received scant attention. this question is a natural extension of the literature examining the cross - border spillovers of the unconventional policy actions taken by the major central banks to provide accommodation. although this literature suggests there are good reasons to expect broadly similar cross - border spillovers from tightening through policy rates as through balance sheet runoff, the effects may not be exactly equivalent. the balance sheet might affect certain aspects of the economy and financial markets differently than the short - term rate due to the fact that the balance sheet more directly affects term premiums on longer - term securities, while the short - term rate more directly affects money market rates. as a result, similar to the domestic effects, while the international spillovers of conventional and unconventional monetary policy may operate broadly similarly, the relative magnitude of the different channels may be sufficiently different that, on net, the two policy strategies have distinct effects. for example, as will be discussed at greater length shortly, the two strategies may have very different implications for the exchange rate. moreover, as was evident with the european central bank ’ s ( ecb ) asset purchases in late 2014 and early 2015, and as we have seen again in reverse in recent weeks, in addition to the standard demand and exchange rate channels, expected or actual asset - 4purchases may have spillovers to foreign financial conditions - - by lowering term premiums and the associated longer - term foreign bond yields - - that are greater than conventional monetary policy. to explore possible differences, it is useful to compare two different approaches to policy normalization, each of which is designed to have identical effects on aggregate domestic activity and thus, at least in the long run, on inflation. at one extreme, a central bank could opt to tighten primarily through conventional policy hikes, while maintaining the balance sheet by reinvesting the proceeds of maturing assets. at the other extreme, a central bank could rely primarily on reducing the balance sheet, while keeping policy rates unchanged in the near term. the question is whether there are circumstances in which the choice of normalization strategies, which are similarly effective in achieving domestic mandates, might matter for the global economy. where the two approaches have entirely equivalent effects, the central bank could freely substitute between them without changing the composition of home demand, and net exports, the exchange rate, and foreign output would also be unaffected. conversely, under different assumptions about the transmission channels of monetary

than under home country adjustment through conventional policy. so far, we have considered the case of central banks with freely floating exchange rates and well - anchored inflation expectations. what about central banks with managed exchange rates or weakly anchored inflation expectations? to keep the analysis simple, let ’ s assume a foreign central bank aims to completely stabilize its exchange rate vis - avis a core country. let ’ s again consider circumstances in which the core country experiences a positive demand shock that calls for policy tightening. although the pegging economy is likely to experience spillovers under either approach to normalization in the core country, the spillovers are likely to be greater when the core country tightens through the policy rate. the tightening in the core country will compel the country that is fixing its exchange rate to tighten policy in sync and the core country ’ s currency will rise more against its trading partners with conventional tightening, leading to greater effective appreciation of the pegging country ’ s currency as well. although the pegging economy will benefit somewhat from the stronger demand of the core country, - 8that benefit is likely to be outweighed by the adverse effects of a tightening of domestic monetary policy when domestic conditions would not otherwise call for it. such considerations may have played a role in the market dynamics experienced by china as discussions about initiating rate hikes progressed in the united states in the second half of 2015 and early 2016. 8 next let ’ s explore alternative approaches to policy normalization by countries facing a similar need to tighten. this question is timely ; with synchronous expansions now underway, we may be approaching a turning point before too long. in particular, let ’ s consider the case when two large countries, which are assumed identical for the sake of simplicity, experience the same positive shock to domestic demand. under these assumptions, if both economies were to choose the same normalization strategy - - putting primary reliance on either the balance sheet or short - term interest rates - - the implications for the exchange rate and net exports are the same : in both cases, the exchange rate between the two countries does not change, and neither do net exports between the countries. each central bank would adjust interest rates by the same amount - - enough to offset the stimulus from the demand shock - - and with interest differentials unchanged, there would be no pressure on the exchange rate between them to move. 9 of course, if there are other economies in the rest of the world that do not experience the same shock, the choice of