Macroeconomic Effects of Tariffs: Insights from a New Open Economy Macroeconomics Model

In this paper a two country new open economy macroeconomics model is applied to analyze both the short-run and the steady state macroeconomic effects of protection. Similar to the traditional Mundell Fleming approach we find that the imposition of a permanent tariff entails a demand diversion effect and a contrarian terms of trade effect, that switches world demand away from domestic towards foreign output. In our case however, the negative terms of trade effect on domestic output unambiguously outweighs the positive effect of demand diversion. Moreover, our analysis reveals that protection raises domestic welfare in the short run, while lowering foreign as well as global welfare. The positive effect on domestic welfare is due to a terms of trade improvement, less labor effort, and consumption exceeding real income, whereas foreigners suffer from the opposite.