The Macroeconomic Effect of Modern Protectionism

Abstract:

This paper estimates the dynamic effects of import tariffs on key macroeconomic aggregates in a small open economy. Due to the countercyclical profile of tariffs, simultaneity between tariffs and GDP induces attenuation bias in the calculation of impulse response functions. To address this issue, we develop a novel instrument based on retaliatory tariffs, constructed from a database of temporary trade barriers. Retaliatory tariff rates are constrained by the World Trade Organization (WTO) to match those imposed by trade partners. The identifying assumption is that tariffs imposed by trade partners are orthogonal to the own economic activity shocks. Retaliation responds to a foreign partner’s defection rather than to domestic economic conditions, allowing the identification of an exogenous import tariff shock using an Proxy-SVAR model. Our key findings are that an increase in tariffs: (i) is inflationary (for consumer prices); (ii) has a negative and quite persistent impact on GDP; and (iii) worsens the trade balance on impact. The results are robust across various alternative specifications and the estimated effects exceed those obtained using standard timing restriction models.