DP20142 Tariffs and Monetary Policy
We study the macroeconomic effects of import and export tariffs in a baseline
New Keynesian open economy model. We show that those effects crucially depend
on the endogenous reaction of monetary policy. Import tariffs can be either
contractionary or expansionary, depending on whether the monetary authority targets CPI inflation or rather a narrow index of domestic goods PPI inflation. Under flexible domestic prices, import tariffs are expansionary
only under a sufficiently high elasticity of substitution between imported and
domestic goods. An exchange rate peg maximizes the expansionary effects of
import tariffs. Conversely, export tariffs are always contractionary, as they
directly affect export demand. The strength of the negative output effect,
however, also depends on the monetary policy regime. In this case,
accommodating (either directly or indirectly) the ensuing depreciation of the
nominal exchange rate is critical to minimize the contractionary output effect
of export tariffs. In response to both tariff shocks, optimal monetary policy
manipulates the exchange rate to achieve a more expansionary stance than the
one that implements the flexible (domestic) price allocation.
