Gains from trade: Understanding the who, how, and when

Although central banks are observers when it comes to setting trade policies, tariffs and trade agreements have a direct bearing on the nation’s monetary policy.

Within the Fed System, one strain of research tries to quantify the effects of specific tariff proposals. Recent papers from trade-focused economists at the Minneapolis Fed, meanwhile, provide a complementary view—one grounded in the strong, theory-focused Minneapolis research tradition. These economists offer enduring insights about how trade shapes the economic fortunes of a nation and its citizens over generations, as well as the difficult choices a central bank must weigh as it pursues optimal monetary policy in the face of trade policies it does not control.

The benefits of trade are bigger than we thought, especially for developing countries

For hundreds of years, economic efforts to quantify the gains from trade have tended to be “static,” comparing one state of the world against another. Principal Research Economist Doireann Fitzgerald takes a “dynamic” approach, modeling the gains over time that arise from international trade as a form of insurance—against the ups and downs of productivity and against the many uncertain future states of the world.

When Fitzgerald models trade “in 3-D,” as she puts it in a recent working paper, she finds the welfare gains from trade are many times greater than traditional estimates in the literature. The dynamic gains from trade are especially large for lower-income, developing countries. In the most conservative calibration of the model, developing countries experience an average welfare gain of 58 percent from open trade (versus a no-trade state). The 3-D gains are more than three times the purely static gains.

Why is this insurance value of trade so much larger for poorer countries? The productivity of less developed countries is more volatile. Advantageous trade terms (in the sense of favorable currency exchange rates) also tend to coincide with periods of lower productivity, so that affordable imports provide a buffer when domestic conditions are weak. The productivity growth rates of developing countries are not closely correlated with those of their trading partners, so trading helps to spread risk over time and space.

Richer countries, by contrast, tend to have less volatile productivity and face the same risks simultaneously. While developed economies do gain from trade, most of those gains come in the traditional, static sense: Specialization and competition make all sides better off than if their economies were isolated.

While trade barriers and agreements have immediate impacts, Fitzgerald demonstrates that many effects of trade policies unfold only in the long run, as interconnectedness provides some assurance against an uncertain economic future.

Trade barriers hurt low-income households the most

It stands to reason that households of different incomes might be affected differently by changes in international trade. Monetary Advisor Michael Waugh finds that for a 10 percent reduction in trade costs, the welfare gain to low-income consumers is more than four times that of the highest-income group. The reason: A price reduction is worth more to the poor than the rich.

Waugh leverages recent empirical findings demonstrating that low-income households have a higher “marginal utility of consumption.” Falling prices provide more value to households with tighter budgets, while rising prices cause relatively more harm to their well-being. Low-income households react more strongly as trade drives down the prices of imports and domestic goods (which are subject to import competition). These households increase their consumption more as their buying power increases, and they are quicker to substitute new products in pursuit of savings.

Compared with models that treat all households the same, Waugh finds that accounting for the “heterogeneity” of household incomes also raises the overall measured benefit of trade, since the gains are so strong for lower-income households.

Arguments for tariffs and other trade restrictions often cite the protection of jobs. Waugh’s research sets aside the labor-market effects of trade in the interest of highlighting the effects on different types of consumers. These evidently large gains-to-trade for low-income consumers could be weighed alongside our best understanding of employment effects to provide a clearer, balanced picture of how trade affects different households.

The bigger threat from a tariff is not inflation but economic slowdown

Amid the robust debate about the effect of tariffs on inflation, Monetary Advisor Javier Bianchi and co-author Louphou Coulibaly find the bigger problem for a central bank is that tariffs make the economy inefficient. They find that the optimal central bank policy is not to raise interest rates to fight rising import prices, nor is it to “look through” tariffs as a one-time impact on prices. Rather, the optimal monetary policy is expansionary—lowering interest rates, boosting employment and economic growth while tolerating higher inflation.

In the model constructed by Bianchi and Coulibaly, a 10 percent across-the-board tariff raises prices for imports. More significantly, the tariff also introduces economic distortions in production and consumption, harming employment and economic growth.

Across various scenarios, the economists confirm the superiority of an expansionary policy over a look-through policy that continues to target zero inflation as before. They trace their findings to an economic misalignment: Consumers and producers facing higher prices on imports cut back more than they should. These economic actors do not account for the fact that tariffs generate revenues that are returned to them via the government. The whole economy slows unduly, causing unemployment to rise. Even at the cost of higher inflation, the monetary policymaker in the model maximizes societal welfare by boosting economic activity, returning people to work and sustaining higher consumption. Inflation is the price worth paying.

Notably, even under this optimal policy, employment and GDP are permanently depressed because of the tariff—especially when the tariff includes intermediate goods needed for production by domestic firms. The economists acknowledge the limitations of their model to embody the complexity and unpredictability of the current trade landscape. Nonetheless, their working paper elegantly captures how a significant increase in tariffs could confront a central bank with a difficult trade-off between inflation and recession. In their model, recession is the bigger problem.

Global forces, domestic mandate

“Trade policy is not the purview of the Federal Reserve,” Minneapolis Fed President Neel Kashkari writes in a recent essay. “However, trade is an important factor monetary policymakers must consider when analyzing and forecasting the path of the U.S. economy in order to determine how best to achieve the dual mandate goals of stable prices and maximum employment.” Kashari explores policymakers’ challenge in balancing the forces—higher prices and slower growth—posed by the latest round of tariffs.

While tariffs and trade wars may come and go, the Federal Reserve’s commitment to rigorous, independent research endures. With resources including a concentration of expertise in sovereign debt and multiple researchers advancing economic models of international trade, the Minneapolis Fed’s Research Division equips Kashkari and other Fed policymakers to understand how the tumultuous global economy affects stability and prosperity here at home.