ECN501 Saudi Electronic University Trade Barriers Tariff Questions Select a developed country that has implemented a tariff, and a developing country that
ECN501 Saudi Electronic University Trade Barriers Tariff Questions Select a developed country that has implemented a tariff, and a developing country that manufactures products that are impacted by that same tariff. The current US and China tariff war cannot be used since these are the two largest economies in the world.
Q1: Investigate the impact of the trade barrier on the developing countrys business sector and quantify the impact, if possible.
Q2: Would you recommend that the developed country eliminate the tariff? Explain your reasoning.
– Embed course material concepts, principles, and theories, which require supporting citations along with at least one scholarly, peer-reviewed reference in supporting your answer unless the discussion calls for more
Book International Economics by Carbaugh, Chapter 4 .
Also attached one journal article
APA style, Times new roman 12 points and around 250-300 words WOLFGANG LECHTHALER
Ben Bernanke in Doha: The Effect of Monetary
Policy on Optimal Tariffs
Trade liberalization can imply slow and long adjustment processes. Taking
account of these adjustment processes can change the evaluation of trade
policy, especially when policymakers care more about the next couple of
years than the infinite future. In this paper, I analyze the setting of tariffs in
a two-country model taking account of adjustment processes with special
emphasis on the effects of nominal price rigidity and monetary policy. I
show that nominal price rigidity induces policymakers with a short planning
horizon to set lower tariffs because it enhances the short-run drop in consumption following an increase in tariffs. Monetary policy that aggressively
fights deviations from its inflation target implies even lower optimal tariffs.
JEL codes: E52, F11, F12, F13
Keywords: dynamic trade model, monetary policy, optimal tariffs.
THE INTERACTION OF MONETARY POLICY and trade policy has so
far been largely ignored in the literature (with Cacciatore and Ghironi 2014, being a
notable exception). This is mainly due to the tendency of trade economists to use static
models, thus ignoring adjustment processes and ruling out the effects of monetary
policy by construction. This is in contrast with the perspective of most politicians
who, driven by the political cycle, are more concerned about the next couple of
years than about the infinite future (the new steady state). Thinking about short-run
adjustment, nominal price rigidity and monetary policy become relevant, since it is
well know that both have an influence on short-run adjustments; see, for example,
Gal?? (2008) for an overview of the empirical evidence on nominal price rigidity and
monetary non-neutrality. In this paper, I take the adjustment process seriously, take
account of the slow adjustment of prices and analyze the implications that monetary
policy gains in this context. I show that price rigidity and monetary policy can have
a substantial effect on the level of import tariffs set by policymakers.
I would like to thank Pallavi Marudkar for her excellent research assistance.
WOLFGANG LECHTHALER is at Kiel Institute for the World Economy (E-mail: wolfgang.lechthaler@ifwkiel.de).
Received December 1, 2014; and accepted in revised form January 31, 2017.
Journal of Money, Credit and Banking, Vol. 49, No. 8 (December 2017)
C 2017 The Ohio State University
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To analyze this question, I use a dynamic two-country model with nominal price
rigidity, as well as endogenous firm entry, firm heterogeneity, and selection into
export markets in the spirit of Melitz (2003), by far the most popular model in
the trade literature today.1 The model I use is a variant of Cacciatore and Ghironi
(2014) (CG henceforth), extended by income-generating import tariffs. I use the
model to simulate the dynamic adjustment after a unilateral increase in tariffs, and
to analyze the optimal setting of tariffs. Following Ossa (2014), I consider three
alternatives for determining tariffs: unilaterally optimal tariffs, Nash-equilibrium
tariffs (trade wars), and cooperatively set tariffs (trade talks). In each case, short-run
adjustments matter and policymakers with a shorter planning horizon tend to set lower
tariffs.
Even though a unilateral increase in tariffs raises consumption in the long run,
it decreases consumption in the short run.2 There are two main reasons for the
short-run drop in consumption. On the one hand, an increase in tariffs raises the
aggregate price level because imports become more expensive. The consumption
of imported varieties goes down and expenditures partly switch toward domestically produced varieties that become relatively cheaper, but the increase in the
aggregate price level makes consumption more expensive and thus tends to lower
consumption; see Larch and Lechthaler (2016) for a more thorough discussion.
On the other hand, an increase in tariffs leads to weaker competition, implying a
larger number of plants in the long run. In the short run, this leads to a considerable increase in investments in new plants. Since a larger number of workers is
bound by the construction of new plants, fewer are available to produce consumption
goods.
In this context, nominal price rigidity implies even slower adjustment in consumption because the shift in the relative price of imports and domestically produced
varieties is slowed down. Furthermore, monetary policy, modeled as a standard Taylor rule, raises the nominal interest rate to counteract the surge in inflation caused by
higher import prices. Consequently, nominal price rigidity implies lower consumption in the short run. In the medium run, however, these effects are overturned so that
nominal price rigidity implies (slightly) higher consumption. This pattern implies
that a policymaker with a very short planning horizon would set lower tariffs under
rigid prices, but a policymaker with an intermediate or long planning horizon would
set higher tariffs under rigid prices.3
Naturally, in this context the conduct of monetary policy matters for the setting
of tariffs. I show that a monetary authority that fights deviations from its inflation
1. Felbermayr, Jung, and Larch (2013) have shown that including firm heterogeneity is crucial when
analyzing optimal tariffs because the restriction to homogenous goods shuts off an important channel.
2. This result is similar to the consumption overshooting in response to trade liberalization in Bergin
and Lin (2012) and the productivity overshooting in Chaney (2005). Empirical evidence distinguishing the
short- and long-run effects of trade liberalization is very scarce. Indirect evidence is provided by Bergin
and Lin (2012) who show that the adjustment at the extensive margin is larger in the short run than in the
long run.
3. By a policymaker with a short planning horizon I mean a policymaker who only cares about what
happens in the next x periods with x being a small number.
WOLFGANG LECHTHALER
:
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target more aggressively increases the short-run cost of raising tariffs and thereby
induces policymakers with a short planning horizon to set lower tariffs. In the extreme
case that the monetary authority keeps prices stable, policymakers might even decide
to abolish tariffs completely. Targeting the output gap has the opposite effect, but
matters quantitatively little.
So does this model help in rationalizing observed tariffs? After all, most theoretical analyses typically yield much higher optimal tariffs than what is observed
in the data (see, e.g., Ossa 2014, for a quantitatively rigorous analysis of optimal tariffs). The standard explanation for this phenomenon is that trade agreements
push tariffs below unilaterally optimal tariffs. My approach provides a potential alternative explanation. Raising tariffs entails short-run costs, which are ignored in
static analyses. These short-run costs are higher in the presence of nominal rigidities, aggressive monetary policy, and endogenous labor supply. A model entailing these features can yield very low optimal tariffs even in the absence of trade
agreements.
This paper relates to two strands of the literature. On the one hand, a relatively
young literature that is interested in the short-run adjustment to changes in trade
policy (see, e.g., Kambourov 2009, Burstein and Melitz 2013, Cos?ar 2013, Alessandria and Choi 2014, Cacciatore 2014, Dix-Carneiro 2014). This literatures has so
far not included the optimal setting of tariffs. On the other hand, my paper connects to the large and growing literature on the optimal setting of tariffs, a question that has a long tradition in international trade. However, virtually all of this
analysis is done in the context of static models (see, e.g., Krugman 1991, Bond
and Syropoulos 1996, Bagwell and Staiger 1999, Yi 2000, Ornelas 2005, Demidova and Rodr??guez-Clare 2009, Felbermayr, Jung, and Larch 2013), comparing
one steady state with the other, thus ignoring the adjustment process and the role
of monetary policy that lies at the heart of my analysis. One notable exception
is Larch and Lechthaler (2013) who also use a dynamic model (in the spirit of
Ghironi and Melitz 2005) to address the question of optimal tariffs and to analyze the
relevance of a policymakers planning horizon. However, their paper assumes flexible prices, while rigid prices are certainly important when thinking about short-run
adjustment processes. The assumption of flexible prices also rules out the analysis
of the interaction between monetary policy and trade policy conducted in this paper.
Cacciatore and Ghironi (2014) also look at the relationship between monetary policy and trade policy but from a different perspective. They analyze how monetary
policy should react to an exogenous drop in nontariff trade barriers, while I analyze
the implications of monetary policy for the optimal setting of income-generating
tariffs.
The rest of the paper proceeds as follows. In the next section, I present the model.
In Section 2, I discuss the parameterization of the model. In Section 3, I discuss
unilaterally optimal tariffs, in Section 4, Nash-equilibrium tariffs, and in Section 5
cooperative tariffs. Section 6 is devoted to the effects of monetary policy. Section 7
briefly summarizes a number of extensions and robustness checks that are discussed
in more detail in an online appendix. Section 8 concludes.
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1. A DYNAMIC TRADE MODEL WITH IMPORT TARIFFS AND NOMINAL
PRICE RIGIDITY
The model I use is a variant of the model presented in CG, which puts the Melitz
framework with endogenous firm entry, firm heterogeneity and selection into export
markets into a dynamic setting with price rigidity. Apart from the success of the Melitz
model to replicate important stylized facts,4 Felbermayr, Jung, and Larch (2013) have
shown that including firm heterogeneity is crucial when analyzing optimal tariffs
because the restriction to homogenous goods shuts off an important channel.
To keep the model simple I assume that labor markets are perfectly competitive,
while CG use search and matching unemployment. In turn I introduce nonresourceconsuming, income-generating import tariffs into the model to analyze their optimal
setting. I keep the description of the model deliberately short, for more details the
interested reader is referred to CG. The technical appendix provides an overview over
all the equations.
The main deviation from Ghironi and Melitz (2005), the first paper to put the Melitz
model into a dynamic setting, is the introduction of rigid prices. To make this tractable,
production is structured in two different layers. The aggregate consumption good is
a CES-aggregate of an exogenous and constant number of varieties. Each variety is
produced by a single firm, so that the number of firms is also exogenously given and
constant. Firms sell their products under monopolistic competition. Changing the
price from one period to the other is associated with quadratic price adjustment costs
ala Rotemberg, which gives rise to sluggish price adjustment in response to shocks.
The product produced by a single firm is itself a CES-aggregate of intermediate
inputs. Each intermediate input is produced by a different plant, owned by the firm.
Plants are destroyed each period with an exogenous and constant probability. To
create new plants, firms need to pay a sunk investment cost. After paying the sunk
investment cost, the firm takes a draw from a random distribution that determines the
productivity of the plant for the rest of its existence. Due to a fixed cost of exporting,
only the most efficient plants export their products.
Thus, in contrast to Melitz (2003), endogenous entry and selection into export
markets do not take place at the firm level but at the plant level. The two-layered
production process allows to separate the problem of price setting under price adjustment costs from heterogeneous productivity and endogenous entry, which allows for
a tractable solution of the model.
The economy consists of two countries, Home and Foreign, each with its own
currency, which implies that each country has its own monetary authority (in contrast
4. The popularity of the Melitz model stems from the combination of being able to capture important
stylized facts, like the fact that only very productive firms export, that exporters are bigger and employ
more workers than domestic firms, and that small firms with low productivity are driven out of the market,
while remaining very tractable. See the empirical studies by Dunne, Roberts, and Samuelson (1989), Davis
and Haltiwanger (1992), Bernard and Jensen (1995, 1999, 2004), Roberts and Tybout (1997), Clerides,
Lach, and Tybout (1998), and Bartelsman and Doms (2000) for evidence concerning the stylized facts.
Recent literature on international business cycles highlights the importance of intraindustry trade and
selection into export markets for business cycle synchronization (e.g., Ghironi and Melitz 2005).
WOLFGANG LECHTHALER
:
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to a currency union where only one monetary authority exists). In the following, I
will describe the equations for Home. Equivalent equations hold for Foreign.
1.1 Households
The representative household at Home inelastically supplies one unit of labor, L,
1 (??1)/? ?/(??1)
consumes the aggregate consumption good C = [ 0 Ci
]
, that is a CES
aggregate of intermediate products Ci with elasticity of substitution ?, and invests
in domestic and foreign bonds, a and a? . The household earns income from labor,
w, from interest payments, r and r ? , from the profits of firms that are distributed
in a lump-sum manner, T f , and from the tariffs that the government earns and
distributes to the households in a lump-sum manner, T t . To pin down the steady state
and assure stationary responses to temporary shocks, I assume that households have
to pay a bond adjustment cost ?, which is reimbursed to the households, T a (see,
e.g., Schmitt-Grohe? and Uribe 2003, Ghironi and Melitz 2005). These considerations
imply the intertemporal budget constraint (in real terms, i.e., in terms of consumption
goods)
?
?
(at+1 )2 + Q t (a?,t+1 )2 + Ct
2
2
f
= (1 + rt )at + Q t 1 + rt? a?,t + wt L + Tt + Ttt + Tta ,
at+1 + Q t a?,t+1 +
(1)
where Q = S P ? /P is the real exchange rate, with P being the domestic price index, P ? the foreign price index, and S the nominal exchange rate. Maximizing the
1??
t Ct
intertemporal utility function E 0 ?
t=0 ? 1?? with elasticity of intertemporal substitution, ? , and discount factor, ?, subject to the budget constraint 1 yields two
consumption Euler equations (one for domestic bonds, one for foreign bonds), a demand equation for each domestically produced variety, Cdi , and a demand equation
for each imported variety, C xi :
??
Ct?? (1 + ?at ) = E t Ct+1
? (1 + rt ),
(2)
Q t+1
??
Ct?? 1 ? ?at? = E t Ct+1
? 1 + rt?
,
Qt
(3)
Cdi,t = Ct
Pdi,t
Pt
Cxi , t = Ct
??
Pxi? , t
Pt
,
??
(4)
,
(5)
where Pdi is the price of a domestically produced variety, and Pxi? the price of an
imported variety.
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1.2 Firms
There is a continuum of firms on the unit interval, each selling a variety, Yi , subject
to the demand functions specified above. However, the demand of a variety, Yi , can
differ from the private consumption of the variety, Ci , because it includes the cost
of adjusting prices (see later). Each variety is produced using a CES production
function aggregating intermediate inputs, y, with elasticity of substitution ? . The
intermediate inputs are produced by M plants owned by the firm, which operate at
different productivity. To build a new plant the firm needs to pay the sunk investment
cost, f e w. Then the productivity z of the plant is drawn from a Pareto distribution
G(z) with minimum z min , and shape parameter k. The productivity of the plant will
stay the same until it is destroyed by an exogenous shock that occurs with probability
? each period.
Each firm sells at the domestic market and at the export market, but not all plants are
used for exporting. In the case of exporting, the intermediate inputs are first exported
and then assembled using the CES production function. Exporting an intermediate
input entails three kinds of costs: a fixed exporting cost, f x ? 0, a proportional iceberg
trade cost, ? ? ? 1, and a proportional, income-generating tariff, t ? ? 1.
Iceberg trade costs and tariffs are conceptually different. The former imply a waste
of resources. If foreign consumers want to consume x units of a domestic good, ? x
goods need to be produced and shipped. (? ? 1)x of the shipped goods melt away so
that only x remains to be consumed. In contrast, tariffs constitute a transfer of money
and not a waste of resources. The quantity produced and the quantity consumed is
the same, but there is gap between the amount that consumers pay and the amount
that producers get, with the difference going to the government of the importing
country.
The fixed cost of exporting only has to be paid for those plants that are actually
exporting. This gives rise to selection into export markets, that is, only a subset
of the plants is productive enough (with z > z x ) to generate positive profits from
exporting. Thus, in contrast to Melitz (2003) there is no selection into export markets
among firms (every firm exports), but there is selection into export markets among
plants.Due to selection into export markets, the composition of the exported variety,
?
Yx = [ z x yx (z)(??1)/? MdG(z)]?/(1??) , will differ from the the composition of the
?
domestically sold variety, Yd = [ zmin yd (z)(??1)/? MdG(z)]?/(1??) .
Due to the two layers of production, the problem of the firm can be separated
into two steps. In the first step, the firms chooses investments in new plants, Me ,
and the export cutoff, z x , to minimize the cost of production. In the second step, the
firm chooses the price of its product to maximize its profits. Because the decision
to build a plant affects not only the present period but also future periods the decision is intertemporal. Thus, the firm minimizes the total present discounted cost
given by
Et
s=t
y
?t,s
Pdi,s
Ps
Ydi,s +
Pxi , s y ?
? Yxi , s + Mei,s f e ws + X i,s Mi,s f x ws ,
Ps
(6)
WOLFGANG LECHTHALER
:
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y
where ?t,s is the stochastic discount factor, Pdi /P is the real cost of the domestically
y
sold variety, Pxi /P is the real cost of the exported variety, and X is the share of
exporting plants. Note that the iceberg trade costs raise the marginal cost of exporting,
while tariffs do not. As explained, iceberg trade costs constitute a waste of resources
and thus increase the marginal cost. In contrast, tariffs constitute a transfer. Therefore,
they show up in the revenue equations of the firm but not in the cost equations.
Minimizing the cost of production implies the following two first-order conditions:
Pxi , t y 1 ?
k + (1 ? ? )
+ Mi,t f x wt = 0,
? Yxi , t
(7)
(1 ? ? ) k
Pt X i,t
Pdi , t + 1 y Ydi , t + 1
Pt+1
Mi,t+1
y
Yxi , t + 1
Pxi , t + 1
+ f e wt+1 ? X i,t+1 f x wt+1 ,
+
X i,t+1 ? ?
Pt+1
X i,t+1 Mi,t+1
f e wt = (1 ? ?) ?t,t+1 ?
1
? ?1
(8)
where the first equation defines the threshold productivity for exporting and the
second equation optimal investment in new plants.
In setting the optimal prices for the domestic and foreign markets, the firm needs
to take account of the cost of adjusting prices. This makes the pricing decision also
an intertemporal decision. I assume quadratic price adjustment costs ala Rotemberg,
with the parameter ? governing the extent of price adjustment costs. As is standard,
I assume producer curre…
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