The Macroeconomic Effects Of Trade Policy - Federal Reserve

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K.7The Macroeconomic Effects of Trade PolicyErceg, Christopher, Andrea Prestipino, and Andrea RaffoPlease cite paper as:Erceg, Christopher, Andrea Prestipino, and Andrea Raffo(2018). The Macroeconomic Effects of Trade Policy.International Finance Discussion Papers ational Finance Discussion PapersBoard of Governors of the Federal Reserve SystemNumber 1242December 2018

Board of Governors of the Federal Reserve SystemInternational Finance Discussion PapersNumber 1242December 2018The Macroeconomic Effects of Trade PolicyChristopher Erceg, Andrea Prestipino, and Andrea RaffoNOTE: International Finance Discussion Papers are preliminary materials circulated to stimulatediscussion and critical comment. References to International Finance Discussion Papers (otherthan an acknowledgment that the writer has had access to unpublished material) should becleared with the author or authors. Recent IFDPs are available on the Web This paper can be downloaded without charge from theSocial Science Research Network electronic library at

The Macroeconomic E ects of Trade PolicyChristopher ErcegFederal Reserve BoardAndrea PrestipinoFederal Reserve BoardAndrea Ra oFederal Reserve BoardFirst version: March 20, 2017. This version: October 1, 2018AbstractWe study the short-run macroeconomic e ects of trade policies that are equivalent in a frictionless economy, namely a uniform increase in import tari s and export subsidies (IX), an increasein value-added taxes accompanied by a payroll tax reduction (VP), and a border adjustmentof corporate pro t taxes (BAT). Using a dynamic New Keynesian open-economy framework, wesummarize conditions for exact neutrality and equivalence of these policies. Neutrality requiresthe real exchange rate to appreciate enough to fully o set the e ects of the policies on net exports.We argue that a combination of higher import tari s and export subsidies is likely to trigger onlya partial exchange rate o set and thus boosts net exports and output (with the output stimuluslargely due to the subsidies). Under full pass-through of taxes, IX and BAT are equivalent butVP is not. We show that a temporary VP can increase intertemporal prices enough to depressaggregate demand and output, even when wages are sticky. These contractionary e ects areespecially pronounced under xed exchange rates.JEL classi cation: E32, F30, H22Keywords: Trade Policy, Fiscal Policy, Exchange Rates, Fiscal Devaluation1IntroductionThere is a longstanding debate about how trade policies can stimulate the macroeconomy. In considering di erent ways of alleviating a deep economic recession within the con nes of the gold standard,Keynes (1931) argued that the U.K. could derive a similar degree of stimulus from raising importtari s and providing export subsidies as through devaluing the pound against gold.1 More recently,We thank our discussants Ralph Ossa, Matteo Cacciatore, Nora Traum, Fiorella Di Pace, and Emmanuel Farhifor very insightful comments as well as seminar participants at the Federal Reserve Board, Federal Reserve Banksof Boston and Philadelphia, Macroeconomic Meetings of the Federal Reserve System, XXIX Villa Mondragone International Economic Seminar, NBER Summer Institute, ITAM-PENN Macroeconomic Meetings, Melbourne InstituteMacroeconomic Policy Meetings, the CEBRA-BOE IFM Annual Meeting, the NBER IFM Fall Meetings, the EuropeanCentral Bank, the XX In‡ation Targeting Conference of the Central Bank of Brazil, and the SED Meetings. The viewsin this paper are solely the responsibility of the authors and should not be interpreted as re‡ecting the views of theBoard of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System.1 Eichengreen (1981) provides a detailed account of the contentious political debate that preceded the United Kingdom’s shift towards protectionist trade policies in the early 1930s.1

there has been renewed interest in the question of how countries constrained by membership in acurrency union can implement tax policies with economic e ects akin to a currency depreciation (e.g.Calmfors 1998 and Farhi, Gopinath, and Itskhoki 2014). The approach of cutting payroll taxes tolower domestic relative to foreign prices, and thus boost external competitiveness, has strong intuitiveappeal. In this vein, a number of countries have reduced payroll taxes and nanced these cuts withVAT increases.However, even if these policies can provide stimulus under xed exchange rates, it is unclear towhat extent they would do so under ‡exible exchange rates. Mundell (1961) questioned whetherthe mercantilist prescription of higher import tari s and export subsidies would stimulate demand ineconomies with ‡oating exchange rates, as “equilibrium in the balance of payments is automaticallymaintained by variations in the price of foreign exchange”. Similarly, Feldstein (2017) and Auerbach,Devereux, Keen, and Vella (2017) have argued that a border adjustment of corporate taxationin e ect taxes imports and subsidies exportsthatwould not a ect the trade balance provided that thenominal exchange rate was free to adjust.In this paper, we examine the short-run macroeconomic e ects of three alternative policies that areequivalent in a frictionless economy, namely a uniform increase in import tari s and export subsidies,a reduction in employer payroll taxes nanced by an increase in VAT rates, and a border adjustmentof corporate pro t taxation. To do so, we use a New Keynesian open-economy framework that buildson contributions by Galì and Monacelli (2005) and Corsetti, Dedola, and Leduc (2010). We analyzethe extent to which these three policies elicit equivalent macroeconomic e ectsand xed exchange ratesunder both ‡exibleas well as their e cacy in providing cyclical stimulus.The rst key nding of our analysis is that the combination of import tari s and export subsidies(IX henceforth) induces expenditure-switching towards domestic goods that tend to boost domesticoutput and in‡ation even under ‡exible exchange rates. While IX policies clearly stimulate demandunder xed exchange rates – as hypothesized by Keynes and corroborated by Farhi, Gopinath, andItskhoki (2014) –our nding that these policies are stimulative under ‡exible exchange rates contrastssharply with the conventional view, in which the exchange rate appreciates enough to fully o set anyallocative e ects of import tari s and export subsidies on the domestic economy.2We lay out the conditions under which the conventional view holds and IX policies are “neutral,”2 See,for instance, the orginal contribution by Lerner (1936) and, more recently, Costinot and Werning (2017).2

i.e., have no allocative e ects, and argue that these conditions appear extremely restrictive and henceunlikely to hold in practice. Crucially, the neutrality of IX policies hinges on the expectation that thereal exchange rate will appreciate permanently, re‡ecting the public’s belief that trade actions willremain in place forever and not induce foreign retaliation (even in the long run). However, historicalexperience suggests that trade policy actions are often reversed or spur retaliation. These reversalsmay occur because the trade policies are implemented as cyclical measures to boost the economy oras a negotiating tool in foreign policy;3 alternatively, they may result from an electoral shift towardsa political party more supportive of free trade.4 Moreover, although some trade policy legislation hasbeen enacted with the expectation that it will remain in e ect for a long timeDepressionas in the Greatthe tari wars that ensued during the 1930s (especially in response to Smoot-Hawley)serve to underscore the high likelihood of foreign retaliation under such circumstances.Given this motivation, we use a Markov-switching framework to consider two mechanisms thatcause the exchange rate to revert to its initial level in the long-run: rst, an eventual abandonmentof the policy; and second, retaliation by foreign countries.5 In both cases, we nd that the policyboosts output so long as the unilateral actions remain in e ect (that is, before the foreign retaliationoccurs). Intuitively, when the exchange rate is expected to eventually revert to its pre-shock level, theimmediate appreciation of the currency falls short of completely o setting the expenditure-switchinge ects of the policy on imports and exports. While the expectation that the policy will be reversedraises the relative price of current consumptionsince tari s are expected to declinethe resultingfall in consumption due to this intertemporal substitution channel is swamped by the boost to netexports, so that output expands. As a matter of fact, a key insight of our paper is that the outputstimulus of unexpected IX policies is largely driven by the export subsidy whereas tari s, depending3 In this vein, Irwin (2013) discusses how President Nixon favored the imposition of a 10 percent across-the-boardtari in 1971 partly to enhance his electoral prospects in the 1972 election, as well as to put pressure on foreigntrading partners to revalue their exchange rates. As it turned out, the tari s were lifted fairly quickly when the foreignpolicy objectives were viewed as largely achieved, as well as from pressure coming even from some members of theAdministration.4 For example, in the U.S. experience, President Wilson, a free-trade Democrat, strongly supported the passage ofthe Underwood Tari Act of 1913 which scaled back the high tari s that had prevailed under previous RepublicanAdministrations (see Irwin 2017).5 In standard DSGE models, expectations about how trade policy will be set in the distant future – by a ecting theexchange rate that must prevail in the long-run to satisfy intertemporal trade balance – can exert powerful e ects onthe exchange rate today. However, such implications rest on the doubtful premise that agents have a high degree ofcon dence about the stance of policy far in the future.3

on parameter values, have a negligible or even contractionary e ect on output.6 ;7We then turn our attention to the analysis of a reduction in payroll taxes nanced by an increasein VAT (VP policy), an alternative tax policy that is often considered either equivalent or a closesubstitute to IX. Some European governments have attempted to provide macroeconomic stimulus byimplementing such " scal devaluations", including the governments of Denmark in 1988, Sweden in1993, Germany in 2007, and Portugal in the context of the 2011-2014 EU-IMF Economic StabilizationProgram.8Our second key nding is that, in general, the e ects of IX policies diverge markedly from VP,even qualitatively. To illustrate the di erent general equilibrium response to these policies it is helpfulto consider the same conditions under which IX is neutralnamely, when policies are implementedpermanently and exchange rates are ‡exible. In this case, neutrality of IX occurs through an immediatejump in the exchange rate which ensures that the price of imported goods remains unchanged relativeto domestically-produced goods; no change in factor prices, including the wage, is required. While VPalso turns out to be neutral –at least if wages are ‡exible –a striking di erence is that no adjustmentin the exchange rate is required to keep the relative price of traded goods constant, re‡ecting that theVAT applies to both imported and domestic goods. Moreover, the wage must jump under VP, bothto o set the competitiveness-enhancing e ect of the subsidy on rm marginal cost, and to inducehouseholds to keep their labor supply unchanged. A direct consequence of these di erent relativeprice responses is that any departure from the speci c conditions that deliver allocative equivalence(and neutrality) will result in markedly di erent macroeconomic e ects. For instance, in the specialcase in which wages are ‡exible but exchange rates are xed, IX has expansionary e ects while VPremains neutral.An important open question remains whether a temporary implementation of VP can providestimulus in the event of cyclical downturns. We nd that a VP policy can easily have contractionarye ects on aggregate demand and in‡ation, even when wages are sticky. While the payroll subsidy toemployers increases competitivenes by reducing marginal costs, the temporary increase in VAT rates6 Our emphasis on intertemporal substitution channels is in the spirit of earlier work by Svensson and Razin (1983),who use a two-period model to illustrate how a temporary tari a ects the current account through intertemporalsubstitution e ects on consumption.7 Barattieri, Cacciatore, and Ghironi (2017) incorporate additional supply-side channels, including endogenous entryand exit of rms, that amplify the negative e ects of tari s. These authors, however, focus exclusively on the e ects oftari s rather than the combination of import tari s and export subsidies (IX policies), as we do here.8 A number of quantitative and empirical papers have tried to gauge the e ects of scal devaluations on trade,including Lipińska and Von Thadden (2012), de Mooij and Keen (2012), Franco (2013), and Gomes et al. (2016).4

raises the price of current consumption relative to future consumption, thus depressing aggregatedemand. The latter intertemporal substitution e ect exerts a strong contractionary impetus unlessmonetary policy cuts interest rates su ciently. Hence, VP tends to be sharply contractionary under xed exchange rates and may well cause output to fall even under ‡exible exchange rates.These results may seem surprising in light of the existing literature, including the seminal work byFarhi et al. (2014), which shows that, under xed exchange rates, VP provides equivalent stimulus tooutput and in‡ation as IX or an exchange rate devaluation. A critical assumption responsible for thecontractionary e ects of VP is that, in our framework, pre-tax prices are sticky, so that VAT increasesare immediately passed through to consumer prices. Given the centrality of this assumption aboutVAT pass-through for our theoretical results, we discuss some empirical evidence in support of ourspeci cation that shows that consumer prices tend to increase quickly in response to VAT increases. Aparticularly applicable case was the implementation of the German scal devaluation in 2007case of a VAT increase accompanied by an equally-sized payroll subsidya rarein which the pass-throughof VAT increases was large and immediate.While our analysis focuses heavily on IX and VP policies, we also study the e ects of a borderadjustment of corporate taxes (BAT). Several authors, including Feldstein (2017) and Auerbach etal. (2017), have recently argued that a border adjustment of corporate taxation, that amounts totaxing imports and subsidizing exports, would not a ect the trade balance provided that the nominalexchange rate was free to adjust. A key theoretical insight of our analysis is that, with nominalrigidities and full pass-through of taxes, the BAT is equivalent to IX. Consequently, the BAT wouldprovide macroeconomic stimulus exactly like IX policies and have no allocative e ects only underfairly extreme assumptions.A few authors, including Barbiero, Gopinath, Farhi, and Itshoki (2018) and Linde and Pescatori(2018), have recently provided quantitative assessments of a possible adoption of a BAT by theUnited States. These papers mainly consider a unilateral permanent implementation of the BATwhich implies a large jump in the exchange rate. They focus on incomplete pass-through of exchangerate changes to import prices as a key source of non-neutrality, and show how, under these conditions,the BAT can have large e ects on both trade prices and volumes. While our analysis has clearcomplementarities with this research, we focus on features – such as the possibility of retaliation orreversal as captured by our Markov-switching framework –that greatly diminish the scope for trade5

policies to exert large e ects on the long-run level of the exchange rate. As emphasized, these featurescause trade policies to have allocative e ects by damping the near-term movement in the exchangerate. Although we retain a standard in nite-horizon general equilibrium framework, our use of aMarkov-switching framework to limit the role of long-run expectations in determining the economice ects of trade policies is in the same spirit as a recent literature that attempts to damp the role ofbeliefs about future policies on current outcomes.9The paper is organized as follows. Section 2 describes the model. Section 3 develops some intuitionabout the e ects of IX, VP, and BAT policies by discussing their partial equilibrium e ects. Section4 discusses the macroeconomic e ects of IX policies, including conditions for neutrality. Section 5investigates the relation between IX, VP, and BAT policies. Section 6 concludes.2ModelThe economy consists of a home (H) country and a foreign (F ) country that are isomorphic instructure. Foreign variables are denoted with an asterisk. Agents in each economy include households,retailers, producers of intermediate goods, and the government. For ease of exposition, the nextsections describe the optimization problems solved by each type of agent under the assumptions ofproducer currency pricing (PCP), fully ‡exible wages, and a simple nancial market structure in whichonly a foreign currency bond is traded internationally. Appendix A presents a more general modelthat allows for alternative assumptions about price and wage setting and nancial market structure,as well as for di erences in country size; all of the theoretical results are derived within the contextof this general framework.2.1HouseholdsHouseholds in the home country derive utility from a nal good consumption (Ct ) and disutility fromlabor (Nt ). They maximize expected lifetime utilityE0t1t 0 U(Ct ; Nt )(1)9 See, for instance, research on the “forward guidance puzzle” by McKay, Nakamura, and Steinsson (2014), Fahri andWerning (2018), and Angeletos and Lian (2017), as well as related analysis of the e ects of nite planning horizons byWoodford (2018).6

subject to the budget constrainthPt Ct BHt "t BF t 2BF tBF2i Rt1 BHt 1 "t R t1 BF t 1 Wt N t e t Tt(2)where Pt is the consumer price index, BHt are noncontingent nominal bond holdings denominated indomestic currency, BF t are noncontingent nominal bond holdings denominated in foreign currency,Rt1is the foreign nominal interest rate, "t is the nominal exchange rate (de ned as the price of oneunit of foreign currency in terms of units of home currency), Wt is the wage rate, e t is the aggregatepro t of the home rms assumed to be owned by the home consumers, Tt is a lump-sum transfer fromthe government. The parameter0 allows for the possibility that home households face quadraticcosts of adjusting their holdings of foreing bonds.10 In our baseline calibration we focus on the case,often considered in the literature, in which foreign households cannot invest in the domestic bond sothat only the foreign bond is traded internationally.11We assume that the period utility function takes the formU (C; N ) 111N 1 1 tCt1(3)Optimality requiresWtPt(4)PtRtPt 1(5)Pt "t 1RPt 1 "t t(6)Nt Ct 1 Et1 Etwheret;t 1CtCt 1 t;t 1t;t 1is the real stochastic discount factor of the home household. The correspond-ing optimality condition for foreign household holdings of the foreign bond is1 Ett;t 1PtRPt 1 t(7)Combining the optimality conditions for bond holdings (6) and (7), one obtains the risk-sharingof our theoretical results go through irrespective of the value of provided that 0: For simplicity, the rstorder conditions we report in the text assume 0: In our simulations we introduce very small costs of adjustment toensure stability of a rst order approximation. See Neumeyer and Perri (2001) and Schmitt-Grohe and Uribe (2003).1 0 All1 1 Thatis, the budgetis given byh constraint for foreign householdsi2Pt Ct BF t "1 BHt 2 BHt BH Rt 1 BF t 1 "1 Rttt1 BHt 1 Wt Nt e t TtIn our baseline analysis we set 1 so that only foreign currency bonds are traded internationally. We considerrelaxing this assumption in Section 4.4.7

conditionEtt;t 1Qt 1QtPtPt 1t 1 0(8)where Qt is the real exchange rate expressed as the price of the foreign consumption bundle in homecurrency relative to the price of the domestic consumption bundle, that isQt "t2.2PtPt(9)RetailersCompetitive home retailers combine home and foreign intermediate goods to produce the nal consumption good according to the constant-elasticity-of-substitution (CES) aggregatorh 11Ct ! H YHt (1where11! H ) YF ti1(10)0 determines the elasticity of substitution between home and foreign intermediate goodsand ! H 2 [0:5; 1] governs home bias. The home good (YHt ) and the foreign good (YF t ) consist of CESaggregators over home and foreign varietiesYHt Z111diYHt (i)(11)0YF t Z111YF t (i)di(12)0where0 determines the elasticity of substitution across varieties.Pro t for the home retailers areRt (1vt ) (1t) Pt CtPHt YHt(1PF tYF tt BATt )where PHt and PF t are the price indexes of the home and foreign goods,rate,tvt(13)is the value-added taxis the tax rate on pro ts, and BATt 2 f0; 1g indicates whether pro t taxes are adjusted atthe border or not. The border adjustment implies that the cost of imported goods (YF t ) cannot bededucted from pro ts. Prices are inclusive of value-added taxes and, in the case of imported goods,are also inclusive of home tari s (mt ).8

Given the CES structure of these aggregators, the home and foreign good demand functions arecharacterized byPHtPtYHt !YF t (1!)Ct(14)PF tt BATt ) Pt(1Ct(15)YHt (i) PHt (i)PHtYHt(16)YF t (i) PF t (i)PHtYHt(17)The zero pro t conditions for home retailers imply that price indexes satisfy:Pt "1!PHt (1PHt !)ZPF tt BATt11#11(18)111PHt (i)1(19)di0PF t Z111PF t (i)1di(20)02.3ProducersEach country features a continuum i 2 [0; 1] of monopolistically-competitive rms that produce different varieties of intermediate goods. Producers use the technologyYHt (i) YHt (i) At Nt (i)(21)where YHt (i) and YHt (i) are rm i0 s sales in the domestic and foreign market, respectively, At is theaggregate level of technology, and2 (0; 1) controls the curvature of the production function.In our benchmark speci cation we assume producer currency pricing (PCP), that is, producers setprices in the domestic currency while letting prices in the foreign market adjust to ensure that unitrevenues are equalized across markets. We can then write rm i0 s pro ts asPt (i) (1t) fPP t (i) [YHt (i) YHt (i)](1& vt ) Wt Nt (i)gwhere PP t (i) denotes the unit revenue from domestic sales of the home variety.9(22)

The presence of value-added taxes introduces a wedge between unit revenues PP t (i) and the pricepaid by domestic retailers for PHt (i) :vt ) PHt (i)PP t (i) (1(23)Similarly, import tari s, export subsidies, and the deductability of export sales from the corporatepro t tax when the border adjustment is in place (i.e. BAT 1) create a wedge between the foreigncurrency price paid by foreign retailers, PHt (i) ; and rm i0 s foreign currency unit revenue fromexports,PP t (i)"t :PHt (i) (1tBATt ) (1 (1 & xt )mt) PP t (i)"t(24)Producers set prices in staggered contracts following a Calvo-style timing assumption and withfull pass-through of value added taxes. That is, a domestic rm that adjusts its price at time t setsthe unit revenues PP t (i) and, absent any price adjustment until time s t; changes in value-addedtaxes are fully re‡ected in retailer’s costs of purchasing the home varietyPHs (i) PP t (i):v)(1s(25)Each rm that reoptimizes at time t will then choose PP t; to solvemax EtXs tPt;s(1s)s twherePPP t (i) [YHs (i) YHs (i)]Ps(1& vs ) Ws Ns (i)(26)is the probability that the rm won’t be able to adjust its price in any given period, labordemand satis es (21) ; and domestic and foreign sales are determined by retailers’demand schedulesin both the home and foreign market (i.e., equation (16) and its foreign analogue, respectively). Thereset price P P t (i) satis es the usual optimality condition:Ets t1s t Pt;s[YHs (i) YHs (i)] (1s)(1 & vs ) Ws 01 As Ns (i) 11P P t (i)Ps(27)Equation (27) indicates that the contract price P P t (i) is set as a xed markup over the appropriatelydiscounted measure of rm marginal costs that takes into account the expected duration that thecontract price will remain in e ect. We let the producer price index PP t be de ned in a way thatmimics the consumer price index in (19) :PP t Z11PP t (i)101di;(28)

our Calvo-style pricing assumption then implies that producer price in‡ation is given byPt "P (1P)#111PP;tPP;t 1(29)Expression (29) indicates that producer price in‡ation depends on future marginal costs through theoptimal reset price PP;t ; which is identical across all rms that reset at time t: Combining equations(27) and (29) one obtains the familiar New Keynesian Phillips Curve linking domestic price in‡ationto current and future marginal costs.Similarly, foreign rm j sells its good in the foreign country at a price of PF t (j) and in the homecountry according to the PCP condition12PF t (j) (1 mt )(1 & xt ) (1v ) "t PP t (j)t(30)Foreign rms that are allowed to reset their price choose their contract price P F t (j) so thatEt2.4s t1s t Ps;tWs1 As Zs (i) Ns (j)[YF s (j) YF s (j)] P P t (j)1 0(31)Government PolicyFiscal policy in the home and in the foreign country is characterized by a vector of scal instrumentsst (m xt ; &t ;v vt ; &t ;t; BATt ;mt; & xt )(32)that are assumed to follow a Markov chain as described below. The home government balances itsbudget in every period through levying lump-sum taxes Ttmt vtPF t YF t 1 mtvt PHt YHt& xt"t PHtYHt 1 m1tttwhere TtI are net international vt Wt Nt TtI Tt(33)Monetary policy follows a Taylor-style interest rate rule:Rt 1('P t)where ' is the weight on producer price in‡ation ('y( yt )P t) ;'"(e"t )(34)'y the weight on the output gap ( yt ) ; and'" determines how policy rates respond to deviations of the nominal exchange rate from an exchange1 2 As we specify later, we assume that the foreign governments does not make use of VP and BAT policies. Hence,unit revenues to producers equal retailers cost in the foreign country (i.e. PF;t PP;t ):11

rate target i.e. e"t "t".13 When '" 0; the home interest rate responds exclusively to ‡uctuationsin output gaps and domestic in‡ation. This speci cation implies that the central bank looks throughchanges in in‡ation due to the direct e ects of tari s and value-added taxes. When '" M , with Mlarge, the interest rate is set so that the country pegs its exchange rate to a predetermined target (").2.5Market Clearing and EquilibriumLabor market clearing equates household supply of labor with aggregate rms’demandNt ZNt (i) di:(35)Bond market clearing requiresBF t BF t 0(36)BHt BHt 0(37)Combining home and foreign households budget constraints and using the bond market clearingconditions we get a balance of payment equilibrium equation"t B F t "t BF t1 Rt 1 N Xt(38)which requires that home households increase their holdings of foreign bonds to meet the total amountof new borrowing demand from abroad, given by home net exports:N Xt "t PHt(YHt(1 mt )St YF t )(39)where St denotes the terms of tradeSt (1 (1 mt )m)t(1vt ) PF t(40)"t PHtwhich is the key relative price determining the behavior of the trade balance.Let the initial condition for home holdings of bonds and individual producer prices in the homeand foreign market be:x0 BF1 R 1 ; PH 1(i) ; PF1(i)De nition. Given an initial state x0 ; a stochastic process for scal policy fst g and internationaltransfers TtI ; an equilibrium consists of (i) an allocation at home,1 3 See fCt ; BF ; Nt ; YHt ; YF t ; YHt (i) ;Benigno et al. (2007) for a discussion of interest rate rules that maintain a xed exchange rate.12

YF t (i)gt0; and abroadPHt (i) ; PHt (i)gtand abroad0; (ii) rm-level prices and production decisions at home,;and abroad; (iii) aggregate prices at home PP t (i) ; Nt (i) ; Pt ; PHt ; PF t ; PP t ;Pt ; Wt ; Rt t 0; (iv) (domestic) bond holdings, net exports, currency exchange rates and terms of tradefBHt ; BF t ; N Xt ; "t ; St g such that:1.The allocation(14 )satis es households and retail rms optimality conditions (4 )(6 ) and(17 ) as well as the analogous conditions in the foreign country;2. Individual producer prices and production decisionsmaximize rm pro ts, i.e. they satisfyconditions (21 ),(23 ) ; (24 ) and (27 ) as well as the analogous conditions in the foreign country;3. Pricesclear all markets. That is, price indexes, Pt ; PHt ; PF t ; PP t ;(20 ) ; (28 )t 0; satisfy (18 )(29 ); wages clear the labor market, i.e. (35 ) is satis ed; and nominal interest ratesare determined according to (34) : Analogous conditions pin down4. The bond market clears, i.e. equations (36 )2.6Pt:(40 ) are satis ed.CalibrationIn our discussion of the transmission of trade policies, we calibrate the model using fairly standardvalues in the literature.14 Table 1 shows our baseline parameter values.Table 1. CalibrationParameterHouseholdsProducersMonetary Policy1 4 See,Discount factorRisk aversionFrisch elasticity of labor supply1Value0:991:001:00Labor sharePrice stickinessTrade elasticityImport share!H0:360:901:250:15Output gap weight in the ruleIn‡ation weight in the rule'y'0:1251:50Pfor instance, Galì (2008).13

3Partial equilibrium e ects of trade and scal policiesThe trade and scal tax instruments considered in this paper directly a ect three key margins determining the equilibrium allocation in our model economy, namely relative demand for home andforeign varieties, for consumption and leisure, and for consumption at di erent dates. In this section,w

The Macroeconomic E ects of Trade Policy Christopher Erceg Federal Reserve Board Andrea Prestipino Federal Reserve Board Andrea Ra o Federal Reserve Board First version: March 20, 2017. This version: October 1, 2018 Abstract We study the short-run macroeconomic e