Macroeconomic Analysis of Tariffs Pt .1

Updated: Oct 23, 2018

Macroeconomic Analysis of Tariffs

Tariffs are a taxes on foreign goods being sold into an economy.  A single tariff is unlikely to have a noticeable effect on the macro economy.  Therefore macro analysis is generally only used to analyze the effect of widespread tariffs that hit a range of imports affecting both consumers and businesses. In our analysis below we’ll assume that the tariffs imposed are wide enough to matter at the macroeconomic level.  

We will explore three key mechanisms through which broad tariffs affect an economy

  1. by increasing the aggregate demand for goods and services;

  2. by decreasing the aggregate supply of goods and services in the short run; and,

  3. by changing saving and investment levels, likely decreasing the economy’s potential GDP.

As we walk through each of these we’ll find that standard macroeconomic analysis consistently produces two predictions:

  1. Significantly higher inflation1; and,

  2. Slower GDP growth2 and, very likely, an actual decline in the economy’s potential GDP itself.

Effects on Aggregate Demand

Something becomes more costly, people generally buy less of it.  In this case, imports are more costly due to the tariffs, so people and businesses will import less.

An economy’s trade balance, or net exports (NX), is the total amount an economy exports (EX) minus the total amount it imports (IM), often written as NX = EX – IM. Decreasing imports means net exports must rise.

Increasing net exports also increases aggregate demand. To see why, imagine for simplicity’s sake that consumers spend about half their disposable income on domestically produced goods and services and about half on foreign made goods and services.  Nothing about the tariff directly affects their disposable income or their desire to consume goods and services in general.  As a result, they’ll continue to spend about the same amount of total money, but due to the tariff they will spend more on domestic goods and less on foreign-made goods than they did before.  This shift away from foreign-made goods means they are increasing demand for domestic goods.  Since all consumers in the economy face the same incentives to switch their expenditures away from foreign goods and toward domestic goods, then the economy’s aggregate demand for domestic goods will rise.

The effect of a widespread increase in demand for domestic goods and services is pretty clear: it will push up the prices of those goods and services. These higher prices will also encourage domestic producers to produce more of the goods, now suddenly in higher demand, and this increases GDP as well.  In summary, the tariffs encourage consumers to buy more domestic goods which pushes prices up but also helps domestic producers and those domestic producers hire more domestic workers.  

Our first prediction then is that tariffs, through their direct effect on increasing aggregate demand, will lead to higher prices across the economy (“higher inflation”) and higher GDP growth.


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