Breaking down tariff shocks

Applied macroeconomics made simple

“Tariff” is now the most beautiful word in the dictionary, according to newly elect president Donald Trump. Tariffs will affect economies all over the world, some more than others. The initial impacts are uncertain, as we are still waiting for the unveiling of the size and extent of what could become a new trade war.

How much will the US tariff imports initially? Which good and from where? Are countries likely to retaliate? These are all questions economists and market analysts alike are trying to find the answers for as we speak.

However, if we assume we have a pretty good idea of what these are, there’s a reasonable understanding around the direction of travel, which can be made simple. Let me walk the reader through how I would tackle these, using just about the necessary amount of math and words (both your time and mine are sacred). Let’s start by describing a model.

The model

Analysts often confuse the purpose of models, thinking the more complex and “complete” a model is the better, and some models are often criticised for not accounting for certain peculiarities here and there. I find that only in few cases this type of criticism tends to hold.

Models are actually intentional simplifications of reality, in order to extract tractable conclusions and tell better stories. Good models break things down into the fewest possible components. Nobel prize winning models simplify complex things into three, sometimes less, variables. This applies to any scientific field.

In this note the model I will show is one I already presented before in an earlier post. It summarises an economy into six variables, followed by an equation for each. The spreadsheet link to today’s exercise is found here. Our toy economy is described by this system of equations:

Where ‘x’ stands for output (GDP), ‘i’ is interest rates, ‘π’ is inflation, ‘g’ is net government spending, ‘q’ is the real exchange rate and ‘i*’ is the international interest rate. ‘c’ parameters are linear coefficients to be calibrated, and ‘ε’ are our shock levers, from which we will introduce tariff impacts from. All variables are described as deviations from their respective long run trends.

Now although this model looks very simple, it covers most concerns of macroeconomic analysts out there. Remaining variables could be inferred from the impacts seen on these anyway.

The solution to this model has already been discussed in the post previously linked, so I’ll skip that part to keep it short if you don’t mind.

The model calibration is presented as below. It aims to reproduce stylised well-documented economic facts about each of these variables. You can play with those as much as you like in the spreadsheet and I’ll discuss circumstances in which changing a few of these coefficients could play an important role depending on which economy you aim to represent.

Source: Voices in my head

That is it for the model section. Now let me take you through how we can shock our variables to draw conclusions from this tool.

Feeding in tariff-like shocks to collect economic impacts

Our next step is driven by narrative guided by economic intuition. We need to introduce ‘ε’ disturbances which would mimic how tariffs would initially impact our toy economy.

Amid tariff wars, all economies are initially very likely to see negative supply shocks. What are these? Well supply shocks happen because firms, good suppliers, are uncertain of what’s about to transpire, but know that tariffs are there to make traditional supply chains more costly. The United States will tariff foreign economies in a way so that its trade deficit against the world somehow shrinks, even if that means making the sourcing of an input more costly both domestically and internationally.

One could argue that supply shocks can be downplayed because some inputs are more substitutable, and that the US economy is large enough to produce most of its inputs on its own. That is true to some extent, but that doesn’t really explain why goods were sourced from abroad to begin with, right? The whole purpose of policy intervention is to divert the economy away from more efficient supply chains to one that would benefit less efficient domestic industries, at the cost of the consumers. So yes, tariffs are textbook supply shocks.

Firms are smart too, their board of directors read the news just like everybody else and know that the cost to replace one unit of good sold is about to become more expensive as tariffs are announced. They will not publicly state that their prices are about to increase, nor necessarily know how much that increase will be, but will be inclined to sell less quantities of what would have been budgeted in an environment without tariffs. This will result in higher prices to consumers. This is the first shock.

Central bankers, and especially the Fed, are well aware of that fact. Inflation is unlikely to follow the same expected path from before a tariff policy talk was introduced. If the Fed’s inflation targeting mandate is trustworthy, then it is only natural we should also expect an impact from an increase in the international interest rate to our toy economy. This is the second shock.

Last but not least, we discussed how tariffs are designed in such a way so that the US shrinks its trade deficit against other countries, right? But bear with me here. We can use what we know about international trade and FX to represent another important shock to the real exchange rate.

Say country X holds a 1% of GDP trade surplus against the US which drives Trump mad. What would he do? Tariff that country so that surplus approaches zero. Markets then are likely to anticipate that to some degree, and, despite uncertainty, know that exchange rates can weaken to smooth the impact to trade. What happens then is the real exchange rate of markets in country X anticipate that reduction in trade and a depreciation takes place in order to offset it. A negative real exchange rate shock to our model is warranted to represent shifts in global trade. This is our third and last shock.

And there you have it, a narrative for shocks in our toy economy. Let’s calibrate numbers that could represent an economy well and see how the dynamics of our model play out over time:

The horizontal axis numbers on charts other than the Phase Diagram represent time in quarters

So here we have a lasting negative impact to output ‘x’, which is driven by an initial increase in real interest rates ‘r’ (defined as ‘r=i-Eπ’) as the central bank raises the policy rate to tackle both an increase in the international interest rate ‘i*’, as well as a supply shock along with a small real exchange rate depreciation ‘q’ that drives inflation ‘π’ up on impact. Domestic governments increase net spending to support a faster recovery in output, and in the medium run so do central banks with lower interest rates, as domestic demand is expected to bring inflation down fast and allow for monetary easing to support the downturn.

This is our benchmark case for most economies in the world.

A calibration exercise

This is a nice story to represent small open economies, those that take US actions and international market actions as given. There is a case to be made that larger economic blocks, such as the Eurozone and the US itself, wouldn’t be affected the same. These aren’t price takers on international market rates, for example. In such cases, small changes to the calibration can be made. These are:

This way, we effectively close the channel from which our toy economy is connected to foreign markets, as if it couldn’t be affected by them. Well, magnitudes aside, the direction of travel is unchanged as the supply shock story alone will have the economy play out much in the same way. The economic cycle is much smoother though, which is to be expected.

There are many ways in which the calibration can be adjusted to the economist’s liking. The spreadsheet is left to those who want to study it.

Concluding thoughts

I have always been a proponent of simple models to uncover deep economic insights, and this post is another attempt to reinforce that message. There are important matters this exercise leaves aside, which are worth exploring:

• To which extent tariffs affect the trends of the variables analysed by the model themselves? If tariffs introduce structural inefficiencies, shouldn’t this reflect into permanent losses to GDP, for example? If yes, how?

• We explored how initial impacts play out, but much was left unsaid about how to calibrate the magnitude of the shocks introduced. How can one guesstimate/calibrate the supply shock assumption for a given economy?

• Could different initial conditions change the dynamics of the impacts shown here? How differently an economy that is growing faster than trend and seeing inflation above the central bank’s target is expected to behave once tariff shocks are introduced?

These are all very good examples of relevant questions that could be answered by either adding further structure to the model here presented and/or by giving it more inputs. I will leave those unanswered for now.

Until next time, and if you enjoyed this post please don’t forget to click on the like, subscribe and share buttons. Thank you for making it this far.