Effects on Aggregate Supply in the Short Run, Continued
The indirect effect of tariffs comes through the increased price level itself. Both our first predictions – the increase in demand and decrease in aggregate supply – are that there will be an increase in the price level. A higher price level (inflation) erodes the purchasing power of everyone’s income in the economy. As people in the economy come to realize that the prices of all goods and services have gone up and will continue going up due to the tariffs, they begin to demand higher wages and salaries at their jobs to offset the higher prices they are paying in stores. This upward pressure on wages pushes up the labor cost in all industries in the economy over time and further raises the costs of production, further reducing aggregate supply. That reduction pushes the price level even higher and reduces GDP growth. Our second prediction then is that tariffs, through an indirect effect on the economy’s aggregate supply, will lead to higher prices across the economy (“higher inflation”) and lower GDP growth as well.