Now let’s turn to the case in which the two central banks choose to rely on different policy tools. 10 In this case, one country responds to the positive shock by hiking its policy rate to reduce output to its initial level, while the second country responds by shrinking its balance sheet.
The country that relies on the policy rate to make the adjustment experiences an appreciation in the exchange rate, a deterioration in net exports and some expansion of domestic demand, while the country that chooses to rely solely on the balance sheet for tightening experiences a depreciation of its exchange rate and an increase in net exports.