Tariffs and Retaliation: A Macroeconomic Analysis

We quantify the macroeconomic effects of large tariff increases in a New Keynesian model calibrated to the United States and the rest of the world. We study both a unilateral 10 percentage point US tariff increase and a retaliatory trade-war scenario of similar magnitude. A central distinction is between short-run dynamics, when prices are sticky and trade and investment adjust gradually, and long-run outcomes after full adjustment. Across a wide range of assumptions on price setting, monetary policy, production structure, and trade elasticities, we find that tariffs are usually contractionary for the tariff-imposing country in the short run. They typically raise inflation, sharply reduce imports and exports, and may temporarily worsen the trade balance. In the long run, tariffs are consistently contractionary, with effects often larger than in the short run because of lower investment, weaker labor supply, and falling imported intermediate inputs. A unilateral US tariff may generate welfare gains through terms-of-trade appreciation, but these gains disappear under retaliation.