The case for expansionary monetary policy
Javier Bianchi and Louphou Coulibaly, in this paper, investigate the optimal monetary policy response to tariffs using a dynamic, open-economy New Keynesian model. The model, with exogenous international relative prices, distinguishes between home-produced and imported goods, allowing for analysis of both final consumption goods and intermediate inputs. The authors consider various scenarios, including temporary and permanent tariff shocks, and evaluate both uniform and differential tariffs.
Findings
- When tariffs are imposed, households and firms perceive import prices as higher, leading to a decline in imports that is larger than socially optimal because they do not internalize the increase in tariff revenue, which raises aggregate income.
- To offset this inefficient contraction in imports, the optimal policy is to stimulate the economy, raising employment and aggregate income. This leads to higher inflation-above and beyond the direct price effects of tariffs.
- Under the optimal policy, inflation temporarily rises (e.g., home goods inflation reaches 0.4% in simulations), while employment remains roughly constant, and the labor wedge becomes negative. This contrasts with a “look-through” policy, where employment falls even if the output gap is kept at zero.
- The expansionary stance holds across various scenarios: whether tariffs are temporary or permanent, whether they apply to final or intermediate goods, and even when tariffs are designed to address other distortions.
- In the long run, inflation returns to zero, but the short-run expansionary policy results in a smaller decline in imports and higher aggregate income compared to a policy that ignores the effects of tariffs on the economy.
The Optimal Monetary Policy Response to Tariffs
Authors: Javier Bianchi, Louphou Coulibaly
From: Federal Reserve Bank of Minneapolis, University of Wisconsin-Madison
The case for a gradualist, accommodative monetary policy
In this paper, Iván Werning, Guido Lorenzoni, and Veronica Guerrieri examine how tariffs affect optimal monetary policy by modeling them as cost-push shocks in a New Keynesian framework with imported intermediates. The authors identify two distortions due to the tariffs: a) a reduced efficiency in input usage; and b) a gap between productivity and wages that drives first-order effects, creating a trade-off between inflation and output.
Findings
- Tariffs ≡ Cost-push shocks:
Imposing tariffs is equivalent to introducing a labor wedge shock in a closed economy, shifting the Phillips curve upward. This creates a conflict between price stability and output stabilization, as tariffs lower potential output. - Optimal monetary policy:
– Short-run accommodation: Central banks should allow temporary inflation to smooth the transition to a lower-output steady state. Output remains above the new natural rate initially, declining gradually.
– Inflation-output trade-off: Zero inflation would require abrupt contraction. Optimal policy tolerates higher inflation to avoid sharp drops in employment and consumption.
-This contrasts with the “see-through” doctrine (ignoring one-time price shocks), as tariffs have persistent effects on marginal costs and welfare.
– Example: For a 20% tariff, optimal policy raises inflation by ~1.5% initially, with output declining gradually over 2–3 years.
Tariffs as Cost-Push Shocks: Implications for Optimal Monetary Policy
Authors: Iván Werning, Guido Lorenzoni, Veronica Guerrieri
From: MIT, University of Chicago
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