Working Paper: CEPR ID: DP14556
Authors: Giancarlo Corsetti; Paul R. Bergin
Abstract: In the wake of Brexit and the Trump tariff war, central banks have had to reconsider the role of monetary policy in managing the economic effects of tariff shocks, which may induce a slowdown while raising inflation. This paper studies the optimal monetary policy responses using a New Keynesian model that includes elements from the trade literature, including global value chains in production, firm dynamics, and comparative advantage between two traded sectors. We find that, in response to a symmetric tariff war, the optimal policy response is generally expansionary: central banks stabilize the output gap at the expense of further aggravating short-run inflation---contrary to the prescription of the standard Taylor rule. In response to a tariff imposed unilaterally by a trading partner, it is optimal to engineer currency depreciation up to offsetting the effects of tariffs on relative prices, without completely redressing the effects of the tariff on the broader set of macroeconomic aggregates.
Keywords: tariff shock; tariff war; optimal monetary policy; comparative advantage; production chains
JEL Codes: F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| symmetric tariff war (D74) | expansionary monetary policy response (E52) |
| expansionary monetary policy response (E52) | stabilizes output gap (E63) |
| expansionary monetary policy response (E52) | increases short-run inflation (E31) |
| unilateral tariff shock (F69) | currency depreciation (F31) |
| currency depreciation (F31) | counteracts tariff's impact on relative prices (F16) |
| symmetric tariff war (D74) | inflationary pressures (E31) |
| tariff-induced economic slowdown (F69) | inflationary pressures (E31) |
| monetary policy (E52) | balance inflationary pressures and output gap (E31) |