Trade Wars and Inflation

President Trump’s trade-war gamble is in full tilt, much to the dismay of economists (and detriment of American producers and consumers). If the recent responses of nations like Canada and China are any indication, tensions will continue to escalate in the coming months.

Economists are largely united in their opposition to protectionism and Trump’s zero-sum rhetoric on the nature of trade. After all, one of the most important takeaways in Econ 101 is that free trade increases wealth by allowing nations to specialize in producing goods in which they hold a comparative advantage (i.e., goods they produce at the lowest opportunity cost). The result is that productivity rises (i.e., the value of the output increases relative to the per-unit cost of the inputs) as nations produce more valuable stuff in a less costly manner. As the division of labor and extent of the market increase, the size of the overall economic pie grows.

In this sense, trading with foreigners is akin to discovering a new production method that enables domestic firms to produce more of a particular good at lower costs. Bryan Caplan masterfully illustrates this lesson in a short videousing David Friedman’s Iowa car-crop thought experiment. “For all practical purposes,” he concludes, “foreign trade isa type of technology, a creative way to reduce our cost of living and thereby raise our standard of living.”

If free trade enhances productivity, how might the opposite — a shift toward protectionism — affect productivity, inflation, macroeconomic activity, and monetary policy? 

If the increased efficiency generated by free trade has roughly the same impact as the invention of a more productive technology, a trade war would have a similar economic impact to a negative supply shock. In terms of the framework of aggregate supply (AS) and aggregate demand (AD), the AS curve shifts inward as domestic citizens either have access to fewer foreign goods (in the case of a complete shutdown of trade) or pay higher prices (in the more common case of a tariff). As a result, the overall price level rises and real output falls. Consumers slash their spending on account of their reduced real income. Producers cut back on production in response to their higher cost of production and the fall in consumer demand. Holding all else constant (including monetary policy), the economy moves up a given AD curve to its new equilibrium in which it intersects the new AS curve. 

How would the Fed respond? The answer depends on its target for monetary policy. Under inflation targeting, the Fed must engage in contractionary policy to counteract the trade-war-induced rise in prices and keep inflation within its desired range. In the AS–AD framework, the Fed would respond to the inward shift in the AS curve by shifting the AD curve inward enough to keep inflation within its target range. This would compound the trade restrictions’ already contractionary impact on real output. 

For this reason, many economists (myself included) favor a nominal-spending target along the lines proposed by Scott Sumner and dozens of monetary economists throughout history. Under nominal GDP (NGDP) targeting, the Fed would not respond to the rise in prices induced by the trade war, just as it would with any other productivity shock in the economy such as a hurricane that destroys dozens of factories or an oil shock that affects firms’ cost of production. Unlike under inflation targeting, the Fed would not engage in contractionary policy. It would instead seek to stabilize the growth of nominal spending in the economy, with any rise in the general price level offset by a decline in real output falling. This would keep the AD curve stable, minimizing the negative effect of the trade war on real output without pushing the economy beyond its sustainable production possibilities frontier. 

What does this imply about optimal monetary policy in the age of trade wars? The most important takeaway is that if we are stuck in a suboptimal world where tariffs and trade wars are inevitable, an NGDP-targeting regime would do a better job of minimizing fluctuations in real output than an inflation-targeting regime. In both cases, real output would inevitably fall. But in the case of NGDP targeting, that decline would be smaller than under inflation targeting, and monetary equilibrium would be maintained. 

Of course, it would be better if we lived in a world without tariffs and trade barriers. Reasonable economists might disagree on the optimal target for monetary policy, but the debate over the merits of protectionism has been long settled. As Henry George aptly summarized it over a century ago: “What protection[ism] teaches us is to do to ourselves in times of peace what enemies seek to do to us in times of war.” Naval blockades are seen as an effective way to weaken our enemies’ economy. Why should we expect effectively blockading our own country through tariffs and trade restrictions to do anything but hurt domestic citizens?

President Trump has assured us that “trade wars are good, and easy to win.” If depressed international economic activity is the president’s idea of winning, Americans might get sick of winning.

Sign up here to be notified of new articles from Scott A. Burns and AIER.

Scott A. Burns

Scott A Burns is an Assistant Professor of Business and Economics at Ursinus College. His research focuses on financial innovation in the developing world, including the mobile money revolution that has taken place in Sub-Saharan Africa. He has published scholarly articles in Constitutional Political Economy, Independent Review, and the Journal of Private Enterprise.

Burns earned his M.A. and Ph.D. in Economics from George Mason University and his B.A. in Economics Louisiana State University.