Ivan Werning

Here is a video of this presentation on Tariffs and the best monetary policy response:

www.youtube.com/live/DoFrOjJ...

Workshop in International Macro
📣 Call for Papers 📣
Montevideo, Uruguay, Dec 10-11

Keynote: Ricardo Caballero

Submit your paper: digitatics.typeform.com/to/rUqHU5hOh...

Final thought...

Optimal Currency Area literature (Mundell) studied when a common currency is not too costly for stabilization.

But if coordination is valuable, our mechanism says a common currency can be strict benefit!

So maybe the Euro was a good idea?... 🤔

Unlike most prior work on issues of coordination...

Our results are not driven by traditional beggar-thy-neighbor (on output, not inflation as here) nor by terms-of-trade-effects (market power, our countries take global price as given).

This leads to what we call an expansionary bias.

In response to a negative supply shock (say, an oil shock), decentralized monetary policy is too loose.
Inflation is too high, output too high. Relative to the coordinated optimum.

Pictures speak louder than words... (Q is the global input price).

Equilibrium must be on red line: world Phillips curve...

...yet countries think they can deviate along the flatter blue line...

...but all that does is raise the price Q and shift their curve! 😳

Intuitive step #1: we show world Phillips curve is typically steeper than the individual country's Phillips curve.

Each central bank thinks 💭 “The cost of lowering inflation is too damn high.”

An ideal world planner 💭 “No! Those global supply disruptions are relative!”

Thus, we uncover an inflationary externality:

Higher output → higher global input demand → higher global input prices → higher global inflation 😭

No country internalizes this feedback.

Key mechanism...

1. Each country takes the world input price (that rises!) as given
2. But jointly, they are affecting it!

Result: Countries do not internalize that by tightening more, they could (collectively) lower the supply in the input. Ergo, they don't tighten enough!
6/N

This turns out to be key and imply that well-acting independent central banks can respond in a manner that creates global inflation.

We model a world with...
– Symmetric small open economies
– Wage & price rigidity (both key)
– A global input (e.g. oil) with world price

Our perspective is that this misses a key mechanism that operates during global shocks.

There is little doubt that the recent inflation had two features: it was global in nature (similar across countries), coincided with supply shocks (energy prices, shipping costs etc).

This flips the usual narrative. For example, here is Maurice Obstfeld...

"by simultaneously all going in the same direction, they risk reinforcing each other’s policy impacts without taking that feedback loop into account. The highly globalized nature of today’s world economy amplifies the risk."

🚨New paper with Veronica Guerrieri and Guido Lorenzoni

Was the recent inflation surge due to a lack of coordination? Can lack of coordination lead to too much inflation?

Yes, we show. Especially in response to global supply shocks.

link to paper: economics.mit.edu/sites/defaul...

1/n🧵

MIT Economics obituary for the legendary Stan Fischer:

t.co/8fgZbnaRCB

Adding an atlernative non-NBER link in case anyone has trouble with that
economics.mit.edu/sites/defaul...

Hope this adds some clarity to the tariff debates.

Thanks for reading!

Link to paper: www.nber.org/system/files...

Our equivalence result gives a simple way to map these shocks onto classic macro models—and solve them analytically

In the process justifying simple intuitions that serve as guiding lines. It's important to check and ground good intuitions!

ots of policy commentary says “central banks shouldn’t respond to tariffs.”

That’s not what our model says.

A better rule: Don’t overreact, but don’t ignore either.

Bottom line...

Tariffs create inflation-output tradeoffs that monetary policy can’t ignore.

The effects show up in the nominal exchange rate too...

In our setup, tariffs raise prices and depreciate the currency.

This echoes recent empirical patterns during trade tensions.

(capital flight is surely another reason, but basic macro+trade can already explain it)

A common idea in policy circles is the "see through principle" (not really grounded in economic theory).

It makes some sense as a simple communication device or slogan, but our model says...

... optimal inflation typically exceeds the mechanical pass-through from tariffs.

The results hold with sticky wages, but then inflation control is even costlier.

Zero inflation now requires deeper recessions and wage deflation.

The optimal policy is still to accommodate—with some inflation.

Here’s what’s NOT optimal...

1. Targeting zero inflation. That would require a sharp contraction in output—too costly.
Letting inflation run a bit helps cushion the blow.

2. "See through principle": hoping inflation rises, but minimally, via direct costs. 9/N

Basically, you can do open economy macro with your closed economy model.

Here are some numerical examples run thro the model...

Technically, our AS IF result is as follows.

-an extra "cost push" epsilon term in the Phillips curve, so it is pushes the curve out.

- the welfare objective is unchanged: dual mandate penalizing inflation and output deviations.

7/N

So tariffs are bad, can lead to sharp hit. Optimal monetary policy smooths the adjustment...

Inflation rises in the short run
Output stays above the distorted steady state
Gradual convergence to lower level follows

6/N

It looks something like this using a basic microeconomic intuition. The economy frontier goes down, but also wages are not equal to actual productivity, they are lower, so labor is distorted down. The second effect is stronger starting from free trade.

Intuition: tariffs lower the natural real wage (due to lower profitability) more than productivity. This creates a positive labor wedge, which drives the cost-push effect.

In fact, technically: the productivity loss is second-order, but profitability loss is first order.

We analytically characterize the optimal response.

Spoiler: it involves tolerating inflation—temporarily.
It involves softening the blow of tariffs on output and labor.

Intuitively ....

Translation: Tariffs shift the Phillips curve up.

The central bank faces a tradeoff: control inflation or support output.

It can’t do both.

So what should monetary policy do?... 5/N

Intuitively, as Powell said, tariffs raise costs and lower productivity. They are a negative supply shock that creates a nastier tradeoff for the dual mandate.

Very intuitive... but international macro models are more involved.

Our result formalizes the simple intuition. 4/N