Trade and currency weapons

Abstract

AbstractThe debate on trade and currency wars has reemerged since the Global Financial Crisis. We study the two forms of noncooperative policies within a single framework. First, we compare the elasticity of trade flows to import tariffs and to the real exchange rate, based on product‐level data for 110 countries over the 1989–2013 period. We find that a 1% depreciation of the importer's currency reduces imports by around 0.5% in current dollar, whereas an increase in import tariffs by 1 percentage point reduces imports by around 1.4%. Hence, the two instruments are not equivalent. Second, we build a stylized short‐term macroeconomic model where the government aims at internal and external balance. We find that, in this setting, monetary policy is more stabilizing for the economy than trade policy. One implication is that, in normal times, a country will more likely react to a trade “aggression” through monetary easing rather than through a tariff increase. However, both instruments are (imperfect) substitutes in the short term, when only one of them is available.