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The Macroeconomic Stabilization Of Tariff Shocks: What Is The Optimal Monetary Response?

Paul Bergin and Giancarlo Corsetti ()

Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge

Abstract: In the wake of Brexit and the Trump tariff war, and a general weakening of the political support for free trade, central banks have been faced with the need to reconsider the role of monetary policy in managing the economic effects of unexpected hikes in tariffs and trade costs. Although tariffs induce a slowdown with rising inflation like supply shocks, their distortionary effects on production and relative prices distinguish them from standard supply disturbances, and thus motivate a different monetary response. This paper studies the optimal monetary stabilization of tariff shocks using a New Keynesian model enriched with elements from the trade literature, including global value chains in production, firm dynamics, and comparative advantage between traded sectors. We find that, in response to tariff shocks, the optimal monetary stance is generally expansionary: central banks support activity at the expense of further aggravating short-run inflation---contrary to the prescription of the standard Taylor rule. If the tariff is imposed unilaterally by a trading partner, currency depreciation partly offsets the effects of tariffs on relative prices, without completely redressing the effects of the tariff on the broader set of macroeconomic aggregates. Remarkably, the country issuing a dominant currency can shelter its economy from the adverse effects of a selective tariff war on comparative advantage.

Keywords: tariff shock; tariff war; optimal monetary policy; comparative advantage; production chains (search for similar items in EconPapers)
JEL-codes: F40 (search for similar items in EconPapers)
Date: 2020-04-06
New Economics Papers: this item is included in nep-cba, nep-dge, nep-int and nep-mac
Note: gc422
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Working Paper: The Macroeconomic Stabilization of Tariff Shocks: What is the Optimal Monetary Response? (2020) Downloads
Working Paper: The Macroeconomic Stabilization of Tariff Shocks: What is the Optimal Monetary Response? (2020) Downloads
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