Tariff Shocks, Exchange Rate Fluctuations, and Capital Controls

Technical Summary: Tariff Shocks, Exchange Rate Fluctuations, and Capital Controls

Problem Statement
This study addresses the macroeconomic implications of escalating global trade protectionism, specifically focusing on the transmission mechanisms of tariff shocks under different policy interaction regimes. While existing literature extensively covers the direct costs of tariffs and their impact on trade balances, there is a need to understand how alternative tariff policy rules—specifically independent tariff rules versus pegged tariff rules (where domestic tariffs respond reciprocally to foreign tariffs)—fundamentally alter the direction and intensity of shock transmission. Furthermore, the paper investigates the role of capital controls as a stabilizing mechanism against these shocks, particularly given the dominant role of the real exchange rate channel in transmitting tariff effects.

Methodology
The author constructs a two-country New Keynesian Dynamic Stochastic General Equilibrium (NK-DSGE) model. The model distinguishes between a domestic economy and a foreign economy, incorporating the following key features:

• Households: Representative agents maximize utility subject to budget constraints involving labor income, capital rental, and holdings of domestic and foreign bonds. Capital controls are modeled as a tax rate on cross-border capital flows.
• Firms: The production side includes monopolistically competitive intermediate goods firms using a CES aggregator of domestic and foreign inputs, and a wholesale sector with Cobb-Douglas production. Prices are sticky, following a Calvo pricing mechanism.
• Tariff Rules: The model explicitly defines two regimes:
  1. Independent Tariff Rule: Domestic and foreign tariffs evolve independently (response coefficients $\rho_{mm^*} = \rho_{m^*m} = 0$).
  2. Peg Tariff Rule: Tariffs are linked, where a change in the foreign tariff triggers a proportional response in the domestic tariff (response coefficients $\rho_{mm^*} > 0$ and $\rho_{m^*m} > 0$).
• Shocks: The analysis focuses on foreign import tariff shocks, domestic tariff shocks, technology shocks, and government spending shocks.
• Quantitative Analysis: The model is calibrated using parameters from relevant literature (e.g., Auray et al., 2025a, b; Poilly and Tripier, 2025) to simulate impulse response functions (IRFs) under both tariff regimes, with and without capital controls.

Key Contributions
The paper claims three primary marginal contributions to the literature:

1. Policy Regime Differentiation: It develops a two-country NK-DSGE model that explicitly distinguishes between independent and pegged tariff policy rules. It demonstrates that the peg tariff rule fundamentally alters the transmission dynamics of tariff shocks compared to independent regimes, providing a theoretical basis for understanding "policy gaming" in trade frictions.
2. Exchange Rate Channel Dominance: The study identifies the real exchange rate channel as the pivotal transmission mechanism. It clarifies that the ultimate macroeconomic outcome of a tariff shock depends on the relative strength of direct price effects versus indirect exchange rate effects.
3. Capital Controls as Stabilizers: The research integrates capital controls into the analytical framework, confirming their effectiveness as an exchange rate stabilizer that buffers the domestic economy from the volatility induced by tariff shocks.

Results
The quantitative simulations yield distinct results based on the tariff rule and the presence of capital controls:

• Under an Independent Tariff Rule:

  • Foreign Tariff Shock: An increase in foreign tariffs leads to a depreciation of the domestic currency. This depreciation lowers export revenues (in domestic currency terms), dampens household consumption, and reduces real output. The indirect effect via the exchange rate channel dominates the direct effect, leading to a decline in inflation, consumption, and output.
  • Domestic Tariff Shock: An increase in domestic tariffs causes domestic currency appreciation. While this dampens export quantities, the appreciation increases the domestic value of export earnings, boosting consumption and output from the demand side.

• Under a Peg Tariff Rule:

  • Foreign Tariff Shock: The impact is reversed compared to the independent regime. A foreign tariff hike triggers a domestic retaliatory tariff response. This response offsets the adverse effects via the real exchange rate channel, leading to an appreciation of the domestic currency (and depreciation of the foreign currency).
  • Macroeconomic Impact: The resulting domestic currency appreciation curbs inflationary pressures, boosts consumption, and stimulates output growth. However, it suppresses export volumes and lowers export prices. Simultaneously, the drop in import prices reduces production costs for intermediate goods. Households rebalance portfolios by reducing domestic bond holdings and increasing foreign bond holdings, resulting in persistent capital outflows.

• Role of Capital Controls:

  • Capital controls act as an effective buffer in both regimes. They significantly reduce the magnitude of real exchange rate fluctuations.
  • In the Independent Regime, capital controls weaken the exchange rate transmission effect, allowing the direct effect of the foreign tariff to dominate, which leads to a slight boost in real output and consumption due to lower inflation.
  • In the Peg Regime, capital controls curb capital outflows and exchange rate volatility, substantially attenuating the transmission of foreign tariffs and reducing the responsiveness of macroeconomic variables.

Significance and Claims
The paper asserts that its findings provide theoretical support for understanding policy interactions in real-world trade frictions. It argues that the real exchange rate is not merely a passive transmission conduit but is actively shaped by the mode of tariff policy interaction. The study concludes that:

1. Tariff policies should be evaluated not just for their direct trade restrictions but for their complex indirect effects via exchange rates.
2. Retaliatory strategies (peg rules) can effectively hedge against adverse foreign tariff shocks if they successfully alter the real exchange rate trajectory.
3. Capital controls serve as a critical macroprudential tool to insulate the domestic economy from external tariff shocks by stabilizing the exchange rate channel.
4. International policy coordination is necessary to mitigate the spillover risks of unilateral tariff measures, which can induce significant volatility in trading partners through exchange rate and trade channels.

The author validates their theoretical mechanisms by comparing model outputs with empirical evidence from the 2025 U.S.-China tariff war, noting that the observed decline in the RMB-USD exchange rate amidst escalating reciprocal tariffs aligns with the model's predictions under a peg tariff rule.