Tariffs and Monetary Policy

Title: Tariffs and Monetary Policy

Abstract: 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 tari¤s are always contractionary, as they directly a¤ect 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.