Trade wars and the optimal design of monetary rules

Stéphane Auray, Michael Devereux and Aurélien Eyquem
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Stéphane Auray: CREST-ENSAI, ESC [Rennes] - ESC Rennes School of Business
Michael Devereux: Vancouver school of economics, University of British Columbia - UBC - University of British Columbia [Canada]
Aurélien Eyquem: UNIL - Université de Lausanne = University of Lausanne

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Abstract: Countries have an incentive to use tariffs to gain advantage over trade partners, but an optimaltariff must weigh the benefits of an improved terms of trade against the costs that the tariff imposes on the domestic economy. In the presence of monopoly distortions and nominal rigidities, the stance of monetary policy may have a large effect on the evaluation of thesecosts. In a global economy where all countries set tariffs unilaterally in a ‘trade war', the final outcome can differ dramatically depending on different monetary policy rules. We set out a model of a trade war in a New Keynesian open-economy model. For any one country, a tariff improves the terms of trade but is costly due to its deflationary effect on the domestic economy. A monetary rule which targets the CPI or stabilizes the nominal exchange rate exacerbates these latter costs, and leads to lower equilibrium tariff rates in a trade war. Furthermore, an optimally delegated monetary rule can in fact completely eliminate a trade war.

Keywords: Protectionism; Trade war; Inflation targeting (search for similar items in EconPapers)
Date: 2025-04
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Published in Journal of Monetary Economics, 2025, 151, pp.103726. ⟨10.1016/j.jmoneco.2024.103726⟩

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-05026363

DOI: 10.1016/j.jmoneco.2024.103726

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