DP16651 Trade Wars Currency Wars
Countries distort trade patterns (‘trade wars’) to gain strategic advantage relative to one another. At the same time, monetary policies are set independently and have spillover effects on partner countries (‘currency wars’). We combine these two scenarios, and show that they interact in deep and interesting ways. The stance of monetary policy has substantial effects on the equilibrium degree of protection in a Nash equilibrium of the monetary and trade policy game. Trade wars lead to higher equilibrium inflation rates. Cooperation in monetary policy leads to both higher inflation and greater degree of trade protection. By contrast, when monetary policy is constrained by pegged exchange rates or the zero lower bound on interest rates, equilibrium tariffs are lower. Finally, when one country has the dominant currency in trade, it gains a large advantage in a trade war.