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examine the effects of the news on tariffs on the macro fluctuations, and how the dynamics may change if the negotiation turns out to fail. With a small open economy dynamic stochastic general equilibrium (DSGE) model with the news on tariff, we study various scenarios. We discuss the case where the agreement is out of expectation which include the degree of adjustment in outcome is higher or lower than the news announced before and what if negotiation turns into failure then leads to no agreement. For the case which the news is realized as expected, we compare the effects such as implement postponed and different length of time for preannouncement. This study may provide some policy implications for the government.
2. Literature review
This paper examines the macroeconomic effects of tariff news in an intertemporal small open economy model with price rigidities. The first macroeconomic study on tariffs can be traced back to Mundell (1961), who refers to the imposition of tariffs as a kind of commercial policy that is less effective than both monetary and fiscal policies. Therefore, the imposition of tariff will cause the deflation and contractionary output and higher unemployment under the flexible exchange rate regime.
In contrast to static circumstances in Mundell (1961), Eichengreen (1981) tries to examine tariff effects with the dynamic setting and adjustment process with a currency substitution model. He finds that considering the intertemporal tradeoff, the imposition of tariff may be expansionary in the short run, but in the opposite direction in the long run. It is because national saving and current account surplus will take place and cause a gradually reversal. The two key assumptions of his work include the static and rational expectation.
To explore more from static analyses with intertemporal optimization framework, Sen and Turnovsky (1989) build a one sector model to examine the tariff effects. They find that the introduction of tariff is contractionary both in the long run and in the short run. However, the decline of the capital stock is accompanied by a current account surplus, and therefore the effect
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on saving is ambiguous. Considering that tariff may affect different parts of the economy, several studies are extended into a multi-sector framework (for example, Gavin 1991 and Turnovsky 1991). Brock and Turnovsky (1993) construct a two-sector framework and focus on the welfare analysis. They find that the imposition of tariff on both consumption and investment goods will raise welfare in the short run but the effect will decline over time.
In recent years, most macroeconomic studies are done in dynamic general equilibrium framework, initiated by Obstfeld and Rogoff (1995) who emphasize micro-foundation, choice theoretic and market imperfect competition. This model was extended by Obstfeld and Rogoff (2000) to an explicitly stochastic environment. While Obstfeld and Rogoff mainly discuss two-country frameworks, other studies use the small open economy framework. For example, Kollmann (2002) establishes a small open economy DSGE model where goods are tradable and the law of one price does not hold to examine optimal monetary policy.
While the above studies do not consider tariff, Fender and Yip (2000) is the first one to examine the macroeconomic effects of tariffs in short run and long run following the framework of Obstfeld and Rogoff (1995). They draw the conclusion that domestic output and employment fall as a consequence of tariff imposition, but tariff’s effect on welfare is ambiguous. When they discuss the effects in the short run, they conclude that temporary tariff on import reduces both the domestic and foreign output. The anticipated tariff on export can only reduce foreign output but have ambiguous effects on the domestic output. Hwang and Turnovsky (2012) discuss the imposition of tariff under nominal rigidity with a two-country DSGE framework to examine the effects of tariff under producer-currency pricing (PCP) and local-currency pricing (LCP). They find that the effects were irrelevant for the flexible pricing scheme, though the mechanism is different. Under nominal rigidity, nevertheless, the currency of pricing can crucially lead to different effects. While they emphasize the nominal rigidity where prices may fail to respond to the unanticipated imposition of tariff, they do not consider the anticipation of tariff. Considering their model which has only one asset (currency), Reitz and Slopek (2005) add an integrated bond market into their model. They want to discuss the situation where the current account can be
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imbalanced in the short run, but the movement in the interest rate and capital.
From the other side, instead of imposition of tariff, some other research focuses on the effects of eliminating trade barrier consistent with the global trend of integration. Konan and Maskus (2000) discuss the effects after the FTA is signed between Egypt and European Union.
Because government revenue is reduced after the tariff is lowered, they have to raise the domestic tax rates to offset the tax revenue loss. However, they find that capital tax was more distorting than goods and service taxes and therefore will cause the appreciation and reduce the real returns. In the recent works with a New Keynesian framework, Ganelli and Tervala (2015) find that the unilateral trade liberalization is welfare decreasing. The benefit of the WTO trade agreement significantly depends on the within-country substitutability and Frisch elasticity.
While the previous works study the effects of imposing or eliminating the tariff, we are interested in the effect of news announcement of tariff reduction which may affect people’s expectation before the policy is implemented. This is related to the news shock in the literature.
The concept that the change of expectation can affect macro economy originates from Pigou (1926), who points out that the optimistic expectation for future may cause the recession when the expectation is unrealized. The famous theory which is called the Pigou cycle unveils the new stream for the expectation theory. Led by Beaudry and Portier (2004, 2006 and 2007), the theory of business cycle driven by the news on the TFP improvement becomes prevalent. The forward-looking household has the incentive to react to the news before it is actually realized.
Beaudry and Portier (2006) provide an empirical study on the stock market to show that the news of TFP progress does affect the investment and consumption. They also provide a model which helps solve the “co-movement puzzle”. 2 Their study helps identify which news can be a factor to stimulate the business cycles, which is called “news driven business cycles”. Beaudry and Portier (2007) introduce a costly distribution system and consider the effects between multi-sectors to make the co-movement possible. Jaimoivich and Rebelo (2009) introduce
2 In traditional RBC model, it is impossible to explain the simultaneous expansion of output, consumption and hours worked of labor after the news of innovation. This is so called “co-movement puzzle”
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capacity utilization and utility function with no income effect in their model. Capacity utilization rate depends positively on consumption, and this makes labor demand shift in response to the change in consumption. The effect of labor demand and real wages introduce a strong substitution effect on leisure, and thus the co-movement becomes possible. Gou, Sirbu and Weder (2015) consider imperfect competition instead. When the producer expect the TFP progress, they will have the incentive to decrease price today. This leads to a fall in desired markup and an increment in real marginal cost, which let the labor demand increase and generate the co-movement. Stephane, Paul and Shen (2009) discuss the case where the news about the TFP is fully realized, unrealized, higher or lower than expectation. We would like to introduce same case into tariff news. And we also analyze in new open economy macroeconomics (NOEM) circumstance.
While the previous studies on tariff all focus on the effects after the tariff policy is fully known to the public, none has considered the effects of news on tariff, by treating the tariff news and its aftermath similar to Stephane, Paul and Shen (2009).
In this study, Section 1 is the introduction and Section 2 provides the literature review.
Section 3 outlines the model. In Section 4 and 5, we explain the specification of parameter values for simulations and the analyses.
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3.1 Goods market
We consider a small open economy with a representative household, firm, and central bank, following the specification of Kollmann (2002). There are two kinds of goods: a variety of intermediate goods and homogenous final goods. Final goods are produced using intermediate goods and are used for consumption and investment in the domestic market, which is non-tradable. We assume that the intermediate goods are monopolistically competitive and are tradable. The types of intermediate goods s 0,1
, and they are tradable. The import, export and domestic use of intermediate goods are denoted with qtm
s , qtx
s and qtd
s respectively. Intermediate goods firm use capital and labor as inputs, which are immobile internationally, to produce. The household owns all capital stock, which is rented to producers, and supply labor. The labor and assets market are perfectly competitive.3.2 Firms
3.2.1 Final goods producer
The final goods producer uses the following production function