The macroeconomic dynamics of tariffs: a symmetric two-country analysis.

• Author: Yip, Chong K.

1. Introduction

   This paper examines the macroeconomic dynamics of tariffs. The adverse microeconomic effects of tariffs have been exhaustively discussed in the international trade literature. However, there are still some debate and discussion on the effects of tariffs on the macroeconomy. In the mainstream open economy macroeconomics literature, it is argued that the impact of imposing a tariff is likely to be contractionary under flexible exchange rates.(1) This view, however, has been challenged first by the Cambridge Economic Policy Group (Cripps and Godley [3]) and more recently by Ford and Sen [7]. Given the fact that commercial policies have recently returned to playing a more central role in policy debates, this then leads to a revival of interest in the effects of tariffs on macroeconomic aggregates.

   One important drawback of the analyses in the literature is that they all assume that the domestic economy faces a given world price of imports, i.e., they focus exclusively on small open economies, with virtually no attention being devoted to two-country models.(2) It is surely a question of relevance to examine the cross-country impact of protection. Although considerable effort has been devoted to examine the international transmission of fiscal and monetary policies recently (Corden and Turnovsky [2]; Svensson and van Wijnbergen [13]), little has been done on commercial policies in a two-country framework.(3) It is our intention, therefore, to relax the small-country assumption to study the transmission effect of tariffs.

   In this paper, we discuss how likely a tariff will be beggar-thy-neighbor. Our main concern is the dynamic effects of a tariff on domestic and foreign aggregates. We pay special attention to the distinction between anticipated and unanticipated permanent tariff changes.(4) The case of a temporary tariff is also examined. The analysis is conducted in a modified two-country Mundell [11] - Fleming [6] - Dornbusch [4] model of two symmetric economies which originally used by Turnovsky [15] to study the international transmission of stabilization policies.(5,6) The choice of the assumption of symmetry is intentional because it allows us to apply the Aoki [1] averages-differences method to solve for the dynamics of the system. This method has the advantages of rendering the analysis tractable and providing insight into the solutions.(7) Moreover, as pointed out by Turnovsky [15, 139] ". . . symmetry is not unreasonable as a first approximation, since there is no a priori reason for, say, the United States and Europe to differ in terms of their aggregate behaviour in any systematic way."

   The organization of the paper is as follows. In the next section, a detailed description of the analytical framework is provided and the Aoki decomposition procedure is applied to the model. Section III studies the steady-state equilibrium and the solutions to the dynamics. The macroeconomic effects of tariffs, both anticipated and unanticipated, are examined in section IV. Section V discusses the effects of a temporary tariff. Finally, there is a sixth, concluding section.

2. The Analytical Framework

   The Basic Model

   The framework adopted here is a dynamic two-country version of the Mundell-Fleming-Dornbusch model studied by Turnovsky [15]. The two countries involved are symmetric in structural parameters so that we can apply the Aoki [1] average-difference solution method to the dynamic system. There is complete specialization in production and a single common trading bond. Perfect-foresighted consumers in each country are assumed not to hold foreign currency.(8) The domestic economy is described as:

   [Mathematical Expression Omitted]

   M - [Pi] = [[Alpha].sub.1]Y - [[Alpha].sub.2]i (2)

   [Pi] = [Delta]P + (1 - [Delta]) ([P.sup.*] + E + T) (3)

   [Mathematical Expression Omitted]

   where Y denotes the real output deviation about its natural rate level; P is the (logarithmic) price of output; [Pi] is the (logarithmic) consumer price index; E is the (logarithmic) nominal exchange rate, defined as the domestic currency price of foreign currency; T denotes the (logarithmic) tariff wedge; finally, i and M represent the nominal interest rate and the (logarithmic) nominal money stock, respectively. The restrictions on the structural parameters are as follows: 0 [less than] [[Beta].sub.1] [less than] 1, [[Beta].sub.2] [greater than] 0, [[Beta].sub.3] [greater than] 0, [[Alpha].sub.1] [greater than] 0, [[Alpha].sub.2] [greater than] 0, 1 [greater than] [Delta] [greater than] 1/2 and [Gamma] [greater than] 0. We denote foreign variables with an asterisk.

   Equation (1) is the goods market equilibrium condition for the domestic economy. Private demand for output depends negatively on the real rate of interest and positively on the relative price. It also depends positively, though less than proportionately, on output in the other country.(9) Equation (2) describes the money market equilibrium; real money demand is a positive function of real income and a negative function of the nominal interest rate. The consumer price index (CPI), given by equation (3), is a weighted average of the home good price and the foreign good price, with the weights being the expenditure shares on home ([Delta]) and foreign goods (1 - [Delta]). Following Turnovsky [15], we assume that residents in both countries have a preference for their respective home good and so [Delta] [greater than] 1/2. Finally, equation (4) gives the sluggish price adjustment of the domestic economy in terms of simple Phillips curve relationship.(10)

   Similar relationships can be postulated for the foreign country:

   [Mathematical Expression Omitted]

   [M.sup.*] - [[Pi].sup.*] = [[Alpha].sub.1][Y.sup.*] - [[Alpha].sub.2][i.sup.*] (6)

   [[Pi].sup.*] = [Delta][P.sup.*] + (1 - [Delta])(P - E + [T.sup.*]) (7)

   [Mathematical Expression Omitted].

   Equations (5)-(8) have analogous economic interpretation as equations (1)-(4). Finally, we close the model with the following interest parity condition implied by the perfect substitutability between domestic and foreign bonds:

   [Mathematical Expression Omitted].

   Equation (9) states that arbitrage by risk-neutral agents keeps the domestic interest rate equal to the foreign rate plus any expected capital gain that can be had by holding wealth in assets denominated in the foreign currency. Under perfect foresight, the anticipated capital gain is set equal to the actual appreciation of the foreign currency.

   The Aoki Decomposition

   Given the "sameness" assumption of the two countries, the dynamic analysis can be simplified by applying the decomposition method of Aoki [1]. The procedure involves the definition of the averages and differences for any variable X, namely,

   [X.sup.a] [equivalent] (X + [X.sup.*])/2 (average),

   [X.sup.d] [equivalent] X - [X.sup.*] (difference).

   As is standard in the literature, we assume the adjustments of prices are sluggish, i.e., P and [P.sup.*] move continuously everywhere, while the nominal exchange rate, E, is free to jump in response to new information. Using (3) and (7) to eliminate the CPIs ([Pi] and [[Pi].sup.*]), we obtain the following decoupled system:

   Averages:

   (1 - [[Beta].sub.1] - [Gamma][[Beta].sub.2])[Y.sup.a] = -[[Beta].sub.2][i.sup.a] (10)

   [M.sup.a] - [P.sup.a] = [[Alpha].sub.1][Y.sup.a] - [[Alpha].sub.2][i.sup.a] + (1 - [Delta])[T.sup.a] (11)

   [Mathematical Expression Omitted].

   Differences:

   [Mathematical Expression Omitted]

   [Mathematical Expression Omitted]

   [Mathematical Expression Omitted].

   With the assumption of symmetry, equations (10)-(12) describe the average world economy. Equations (10) and (11) are the corresponding IS and LM curves, respectively, and equation (12) is the Phillips curve that determine the adjustments of the average price level. To assure well-behaved stability properties, we assume the IS curve, (10), to be downward sloping in the [Y.sup.a] - [i.sup.a] space, which requires the following...