How Exchange Rates Absorb Tariff Shocks

When trade wars weaken the dollar

In this paper, Daniel Ostry, Simon Lloyd, and Giancarlo Corsetti study how exchange rates respond to tariff shocks, distinguishing between unilateral tariffs and retaliatory trade wars. The authors construct a new database of US and foreign tariff announcements and implementations for 2018–2020 and 2025, coding each event’s date and size as an “effective tariff‑rate shock” (tariff rate × share of imports affected). They then regress daily changes in exchange rates (USD and EUR effective rates, and EUR/USD bilateral) on these tariff shocks using local projection regressions, with interactions to distinguish between unilateral US tariffs and those met with foreign retaliation.

​Findings

• Unilateral US tariffs (no retaliation): The USD tends to appreciate in response to effective US tariff shocks, both in effective terms and against the euro. This matches the conventional view that tariffs shift demand toward domestic goods and strengthen the home currency.
• ​US tariffs with foreign retaliation (trade wars): When there is retaliation by China, the euro area or Canada, the marginal effect of retaliation is strongly negative for the USD. In the 2018–2020 “global” events, the estimated retaliation effect is large enough that, conditional on retaliation, the USD actually depreciates in effective terms and against the euro.
• ​Magnitude difference: For global events in 2018–2020, a 1 percentage point US effective tariff shock without retaliation yields a peak USD appreciation of around 1.5%, but the marginal retaliation effect peaks near −6%, implying net depreciation when retaliation occurs.
• Consistency with theory: This pattern is consistent with dominant‑currency models: in a symmetric trade war, US monetary policy optimally (or under simple rules) tends to be more expansionary than in the rest of the world, because USD pricing insulates US import prices from exchange‑rate movements. That reduces the US trade‑off between inflation and activity and encourages a weaker USD relative to non‑US currencies.
• 2025 “Liberation Day” tariffs: Applying the same framework to 2025, the paper finds that US tariff actions again depreciate the USD, both in effective terms and against the euro. Given that post‑2 April 2025 US tariffs are all retaliated against and broad in scope, the observed USD depreciation is in line with the trade‑war pattern obtained from 2018–2020. If anything, conditional on a linear model, the depreciation is smaller than predicted by earlier episodes, not larger.
• Bond yields in 2025: What is truly unusual in 2025 is not the USD depreciation but the spike in long‑maturity US Treasury yields following the Liberation Day tariffs, which the authors interpret as evidence of a “reserve‑currency shock” (a fall in the safety premium on US assets), going beyond standard trade‑war models.

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Trading blows: The exchange-rate response to tariffs and retaliations
Authors: Daniel Ostry, Simon Lloyd, Giancarlo Corsetti
From: Bank of England, European University Institute

Exchange rates and optimal monetary policy under tariffs

Paul R. Bergin and Giancarlo Corsetti, in this paper use a two-country, two-sector New Keynesian model to derive optimal monetary policy responses to tariffs. The authors distinguish between a differentiated goods sector (manufacturing, with monopolistic competition and sticky prices) and a non-differentiated sector (commodities, with perfect competition and flexible prices). Both sectors feature trade costs and global value chains. Bergin and Corsetti compute Ramsey-optimal monetary policy that maximizes joint welfare across both countries, subject to the economy’s constraints. They calibrate key parameters to match empirical trade elasticities, tariff persistence, and sectoral trade shares, then use impulse response analysis to simulate optimal monetary responses to tariff shocks under different price-stickiness assumptions.

Findings

Unilateral tariff on differentiated goods imports:

• Optimal policy calls for foreign currency depreciation to offset the tariff’s distortion on relative import prices. This depreciation is achieved through foreign monetary expansion relative to home; the tariff-imposing country typically pursues small or contractionary policy.
• The depreciation offsets approximately half of the tariff’s relative-price distortion, reducing the inefficient sectoral reallocation that would otherwise occur.

Tariff on non-differentiated goods (flexible-price sector):

The tariff itself triggers home currency appreciation through arbitrage in the perfectly competitive sector. Optimal policy is for home to expand monetary policy to offset this appreciation and stabilize export demand for differentiated goods.

Critical role of price-stickiness regime:

• Under producer currency pricing, the exchange rate is the main policy tool: depreciation  or appreciation directly affects import prices faced by consumers and firms’ export demand.
• Under local-currency pricing, exchange-rate pass-through disappears, limiting the exchange rate’s ability to redress tariff distortions; instead, monetary policy must work through demand stabilization channels.

The optimal monetary response depends critically on whether exchange rate adjustment can effectively offset the tariff’s distortion on relative prices, which in turn hinges on the sector targeted (sticky vs. flexible prices) and the invoicing regime (producer vs. local currency). Exchange rate management is central to understanding when and how much monetary expansion or contraction is warranted.
Monetary stabilization of sectoral tariffs
Authors: Paul R. Bergin, Giancarlo Corsetti
From: University of California at Davis, European University Institute