How trade frictions drive inflation: evidence from global value chains
This paper by Pablo Cuba-Borda, Albert Queralto, Ricardo Reyes-Heroles, and Mikaël Scaramucci uses both empirical and theoretical approaches to study how trade cost shocks affect inflation. The authors construct bilateral trade costs for 44 countries from 1995 to 2020 using global input-output tables combined with gravity equations, inferring trade costs as residuals that explain bilateral trade flows through the Head-Ries index. The empirical strategy employs panel local projection methods with country and time fixed effects alongside macroeconomic controls to identify causal effects from cross-country variation in import costs.
The authors develop a dynamic multi-country New Keynesian model featuring trade in final and intermediate goods with staggered price and wage adjustments, calibrated to observed trade flows across five global regions.
Findings
- Inflation impact: A 10 percentage point increase in import costs raises inflation by approximately 0.6-0.7 percentage points initially, with persistence depending critically on whether shocks affect final goods or intermediate inputs.
- Differential effects: Final goods trade cost shocks produce large but short-lived inflation spikes, while intermediate input cost shocks generate more persistent inflation lasting up to five years by propagating through global value chains and raising firms’ marginal costs.
- U.S.-China trade war: Applying the framework to the 2018-2019 trade war, the authors find it raised U.S. inflation by up to 0.3 percentage points annually and reduced GDP by around 0.4 percent, with more persistent effects than simple tariff pass-through estimates suggest.
- Post-pandemic inflation: Trade cost shocks contributed about one percentage point to U.S. inflation in 2022-2023, helping explain inflation persistence during the post-pandemic period.
- Monetary policy implications: Monetary policy rules targeting only domestic producer prices cannot effectively “see through” intermediate input trade cost shocks, unlike their effectiveness with final goods tariffs.
Trade Costs and Inflation Dynamics
Authors: Pablo Cuba-Borda, Albert Queralto, Ricardo Reyes-Heroles, Mikaël Scaramucci
From: Federal Reserve Board, Federal Reserve Bank of Dallas, UCLA
Trade fragmentation and inflation dynamics: the role of adjustment speed
Ludovica Ambrosino, Jenny Chan, and Silvana Tenreyro, in this paper, develop a two-sector (tradable and non-tradable), small open-economy New Keynesian model with household heterogeneity to analyze trade fragmentation effects. The model features:
- Two household types: Unconstrained agents with access to financial markets and constrained hand-to-mouth consumers (30% of population) who consume only labor income
- Imperfect international risk-sharing via costly adjustment of foreign bond holdings
- Rotemberg price adjustment costs in the non-tradable sector to capture nominal rigidities
- Two fragmentation mechanisms: (1) gradual or front-loaded increases in import prices, and (2) gradual deterioration in tradable sector productivity
The authors compare outcomes under Taylor-rule monetary policy to a constrained-efficient allocation and examine how elasticities of substitution, openness, and imported input shares affect results.
Findings
- Gradual fragmentation (persistent import price increases) produces disinflationary stagnation: aggregate demand falls more than supply as households anticipate permanent income losses, leading to falling domestic inflation that offsets rising imported inflation. The natural real rate declines, requiring monetary easing.
- Front-loaded fragmentation (sudden import price spikes) creates temporary stagflation: CPI inflation spikes while demand contracts, necessitating monetary tightening despite output falling. The natural rate remains unchanged.
- Productivity deterioration in tradables has moderately inflationary effects: while real wages fall less than in import price scenarios, higher marginal costs in tradables push up CPI inflation modestly, with a small decline in the natural rate.
- General equilibrium effects matter: Conventional views focus only on supply-side inflationary pressures, but the demand-side response through lower real incomes can dominate, making fragmentation disinflationary in gradual scenarios.
Trade Fragmentation, Inflationary Pressures and Monetary Policy
Authors: Ludovica Ambrosino, Jenny Chan, Silvana Tenreyro
From: London Business School, Bank of England, London School of Economics
