Exchange Rates and Monetary Stabilization of Tariff Shocks

Home currency appreciation can neutralize the relative price distortions created by a tariff, moderating the rise in home import prices. A combination of domestic and foreign monetary policy appropriately managing the exchange rate can thus improve the trade-off between the objectives of supporting domestic demand and containing inflation. Using a New Keynesian two-country model, we analyze the role of the exchange rate in the optimal stabilization of unilateral home tariff shocks hitting, respectively, differentiated sticky-price goods and non-differentiated flexible price goods. In response to a tariff on the former, the cooperative Ramsey optimal monetary policy prescribes home appreciation, implemented mainly through a robust foreign monetary expansion. The monetary response in the home (tariff-imposing) country may be expansionary or contractionary, depending on trade elasticities, but it tends to be modest. If tariffs instead are imposed on flexible-price goods (commodities), the Ramsey optimal monetary response is the opposite, calling for a robust home monetary expansion containing home currency appreciation.