By Paul Bergin and Giancarlo Corsetti
http://d.repec.org/n?u=RePEc:cam:camdae:2026&r=dge
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.
It is hard to find a good economic justification for a tariff war. Thus, the role of the central bank is in a sense to patch up the mistakes of the government (which calls into question the independence of the central bank). But this is imperfect, and the tariff war still leaves marks. And it makes the core goals of the central bank more difficult to achieve as it is distracted.
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