Trade fragmentation, inflationary pressures and monetary policy

Ludovica Ambrosino, Jenny Chan and Silvana Tenreyro

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: How does trade fragmentation affect inflationary pressures? What is the response of monetary policy needed to sustain inflation at target? To address these questions, we develop a two-sector, small open-economy model that features imperfect international risk-sharing and household heterogeneity, capturing both the supply-side and demand-side effects of fragmentation. In the model, fragmentation takes the form of import-price increases or a decline in tradable-sector productivity. The sign and magnitude of its impact on inflationary pressures, and the appropriate policy response, depend not only on the direct effect of higher import prices or lower productivity on supply but also, crucially, on how aggregate demand adjusts to lower real incomes. In turn, this depends on the pace of fragmentation (gradual versus front-loaded) and other key structural factors highlighted by the model. We compare outcomes under Taylor-type monetary policy rules to a constrained-efficient allocation.

Keywords: monetary policy; trade fragmentation; open economies; inflation; heterogeneity; globalisation (search for similar items in EconPapers)
JEL-codes: F12 F15 F41 (search for similar items in EconPapers)
Date: 2026-10-01
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Published in Journal of International Economics, 1, October, 2026. ISSN: 0022-1996

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