Dynamic Impacts of Intermittent Trade Conflicts

This paper examines how intermittent trade conflicts affect production, investment, and exports of an industry that produces for both domestic and international markets. We construct a dynamic stochastic model of a representative profit maximizing firm that is exposed to intermittent trade conflicts. We then extend the firm-level model to an industry comprising a continuum of firms with heterogeneous production costs and calibrate its parameters to reflect the stylized facts of Chinese manufacturers between 2005 and 2007. We find that an exporting firm’s response to the eruption of a trade conflict depends critically on its cost of production, with low-cost firms temporarily adjusting production but continuing to export, and high-cost firms permanently exiting the international market. We also find that an industry can respond quickly to the onset and cessation of a trade conflict. We further predict that in the long run, the severity of trade conflicts has increasing marginal impacts on industry exports whereas the duration and frequency of conflicts have diminishing marginal impacts. Lastly, we argue that if the government desires to fully restore industry exports or value to pre-conflict levels, the most efficient policy is to subsidize capital investment