Tariffs have returned as instruments of economic and geopolitical policy, but their short- and medium-run macroeconomic effects are still not fully understood. This column introduces a new framework that integrates global production networks into a standard open-economy model. It shows that tariffs act simultaneously as demand and supply shocks, and their macroeconomic effects depend critically on production networks, price rigidities, and monetary policy responses at home and abroad. Once these features are incorporated, even transitory tariffs can generate persistent inflation, large output losses, and global spillovers absent retaliation.
Tariffs have returned as instruments of economic and geopolitical policy. Recent VoxEU columns document how the 2025 US escalation has disrupted trade flows, supply chains, and the global outlook (Conteduca et al. 2025, Cerdeiro et al. 2025). The traditional trade literature focuses on long-run welfare and terms-of-trade effects under flexible prices, but the short- and medium-run macroeconomic effects of tariffs in economies with nominal rigidities, production networks, and financial frictions are far less understood. Because modern economies are linked through global production and finance networks — and prices in many sectors, especially services, adjust slowly — trade distortions propagate across firms, sectors, and countries in ways that standard open-economy models miss.
This column summarises a new framework that integrates global production networks into the standard New Keynesian open-economy model used by central banks, with incomplete financial markets (Kalemli-Özcan et al. 2025). The central message is that tariffs act simultaneously as demand and supply shocks, and their macroeconomic effects depend critically on production networks, price rigidities, and monetary-policy responses at home and abroad. Once these features are incorporated, even transitory tariffs can generate persistent inflation, large output losses, and global spillovers absent retaliation.
The model nests a wide class of open-economy models in five equations: an IS curve, a producer-price Phillips curve, a CPI definition, an uncovered interest parity (UIP) condition, and a balance-of-payments equation. It delivers two novel analytical objects. The first is a risk-sharing wedge: under incomplete markets, tariffs redistribute wealth across countries through changes in terms of trade, exchange rates, and net foreign asset positions. The second is an New Keynesian open economy propagation matrix — a dynamic network object akin to a Leontief inverse — that governs how tariff-induced cost distortions move through global production networks over time. These objects deliver three core insights:
- Inflation persistence arises from network granularity: with multiple sectors, lagged sectoral cost distortions feed into current inflation, generating longer and more sluggish responses.
- Tariffs are generally stagflationary in global equilibrium: direct pass-through and imported-input costs raise consumer and producer prices, while sticky prices and input complementarities prevent immediate output adjustment.
- Exchange rates and consumption depend on wealth transfers: absent uncertainty and symmetric retaliation, tariffs can appreciate the dollar by improving US terms of trade, but tariff uncertainty (financial channel) or expected retaliation (expectations channel) can reverse this force and generate dollar depreciation.
The devil is in the details
Canonical trade models treat tariffs as import taxes that shift consumption toward domestic goods. They distort demand, and their short-run effects can be benign or even expansionary for large countries with high import substitution. This view ignores that modern production relies heavily on imported intermediate inputs complementary to labour, and that prices are sticky and heterogeneous across sectors.
When firms source inputs globally, tariffs raise marginal costs directly. These cost hikes propagate through production networks to downstream sectors not directly exposed to trade, including non-tradables such as services. Tariffs therefore distort both consumption and production decisions, acting simultaneously as demand and supply shocks. The combination of these shocks — working through terms of trade, exchange rates, and valuation effects — determines the wealth transfer between countries.
Three channels are central. On the demand side, higher consumer prices reallocate expenditure toward domestic goods within a period and, intertemporally, toward periods without tariffs. On the supply side, higher imported-input costs reduce output and measured productivity. Tariffs also shift relative wealth across countries, moving consumption, exchange rates, and current accounts. The relative strength of these channels depends on substitution elasticities, the global input-output structure, trade imbalances, and heterogeneous monetary-policy responses.
Why production networks matter for inflation dynamics
Production networks fundamentally alter inflation dynamics under nominal rigidities. Sectors differ in price-setting behaviour and in their position within the network. When a tariff raises costs in upstream sectors — energy, basic materials, key manufacturing inputs — the increases cascade through the network, affecting downstream prices over time.
With staggered price adjustment, this propagation generates inflation persistence. In one-sector models, a transitory cost shock mostly produces a one-time inflation increase. With many sectors and network interactions, past sectoral cost distortions feed into current inflation — the mechanism captured by the New Keynesian open economy propagation matrix. Even temporary tariffs can therefore generate prolonged inflationary pressures, and monetary policy faces a sharper inflation-output trade-off: stabilising inflation requires sustained tightening, which amplifies output losses. Stagflation emerges not from an exogenous supply disruption like an oil shock, but as an endogenous outcome of trade distortions interacting with production networks.
Figure 1 Model and policy counterfactuals for US inflation, real GDP, and consumption under tariffs implemented as of March 2026
Notes: The top row compares the baseline with variants that remove input-output linkages, retailers, price stickiness, or open-economy spillovers; the bottom row compares monetary-policy rules. Omitting production networks and using a ‘small open economy’ overstates inflation and understates the output loss.
Figure 1 illustrates how much the network channel matters. The top row varies model features one at a time, holding the tariff scenario fixed at US measures in place as of March 2026. Stripping out the global input-output structure (‘No IO’) or treating the US as a small open economy (‘SOE’) raises the inflation response and shrinks the output decline, because the supply-shock component of tariffs disappears once imported intermediates no longer feed domestic marginal costs. Removing the importing sector (‘No Retailers’) amplifies inflation by forcing tariffs to pass through fully and instantaneously to consumer prices, and turns the consumption response negative. Fixing expenditure shares (‘All Cobb-Douglas’) strengthens terms-of-trade gains and raises US consumption further. Models without production networks therefore systematically overstate inflation and understate the output cost of tariffs, missing slow-moving propagation across sectors, countries, and time.
The bottom row fixes the model and varies the monetary policy rule. US inflation responds most differently under ‘Fixed Nominal Demand’ and under an active US Taylor rule that has the Fed react to tariff-induced CPI movements rather than look through them. In both cases, the central bank accommodates less of the price increase, lowering inflation at the cost of weaker output. Foreign policy choices also have bite. A euro area real-rate rule stabilising consumption weakens the euro, cuts euro area imports from the US, and pushes US output persistently lower, while a stronger dollar produces a more persistent rise in US consumption. China’s exchange-rate stabilisation works through a different channel, altering the path of dollar pass-through. Domestic outcomes under tariffs depend not only on the home central bank’s response, but also on the rules of major trading partners.
Exchange rates, incomplete markets, and wealth transfers
Tariffs also have important implications for exchange rates and international financial flows. Under incomplete markets, exchange rates equilibrate both goods and asset markets, so they are not only relative-price adjustments — they also mediate wealth transfers across countries induced by trade policy.
In a one-sector model, when a large country imposes unilateral tariffs, its currency tends to appreciate: expenditure shifts toward domestic goods, which the tariff also makes relatively scarce and valuable. This improves home terms of trade and transfers wealth toward home; in our notation, the risk-sharing wedge is negative.
Production networks can flip the sign of the wedge and of the exchange-rate response. When the tariffed goods are upstream inputs used by domestic firms, the tariff raises home production costs and can make downstream output scarcer. If the home country tariffs imported semiconductors used in chip production, domestic chips become more expensive; if foreign firms also rely on those chips, the shock propagates abroad. When input complementarities are strong, this network scarcity effect can dominate expenditure-switching, moving terms of trade against home. The risk-sharing wedge then turns positive: the tariff transfers wealth away from the tariff-imposing country and lowers home consumption.
The role of expectations and tariff threats
Expectations are an important and often overlooked dimension of trade policy. We study reversed tariff threats: tariffs are announced, agents expect them to be implemented with retaliation, and they are withdrawn before implementation. This isolates the macroeconomic effect of announcements alone.
The effects are sizable. Using Liberation Day tariff rates, the reversed-threat experiment raises US inflation by 0.34 percentage points on impact, lowers consumption by 0.25%, raises real GDP by 0.27%, and depreciates the trade-weighted dollar by 2.66%. When the reversal is revealed, the exchange rate adjusts immediately, but inflation, consumption, and output take several quarters to return to steady state.
The mechanism is expectations. Agents adjust consumption and pricing based on anticipated trade barriers, and exchange rates respond immediately, front-loading expected changes in trade flows. Tariff threats can therefore generate inflation, output movements, and exchange-rate adjustments before any actual tariffs are imposed.
World trade rewired
Figure 2 illustrates how the global trade network rewires over this horizon. The dominant pattern is US decoupling: US trade with major blocs contracts, with the sharpest declines in flows with China, the rest of the world, and the euro area. The only exception is a small rise in euro area exports to the US (+0.9%), reflecting milder tariff treatment of euro area goods. Outside the US, the picture is one of trade diversion rather than uniform decline. Euro area trade with China, Mexico, and the rest of the world expands along most edges, and several non-US pairs — notably China-Canada and Mexico-rest of the world — register sizable positive changes. Even bilateral flows that do not directly involve the tariff-imposing country are reshaped through the global production network — precisely why a tariff shock in a large economy operates as a global macroeconomic shock in our framework.
Figure 2 The rewiring of the global trade network
Notes: Left panel: bilateral trade shares from the OECD Inter-Country Input-Output Tables for 2022. Right panel: model-implied changes in bilateral trade flows 12 quarters after the US tariff measures implemented through March 2026. Arrow widths scale with the trade share (left) and with the absolute value of the change (right). Thin red lines indicate predicted flows falling relative to the pre-tariff baseline; thick red lines indicate flows rising relative to it.
Policy implications
The analysis yields several implications for policymakers.
First, evaluating trade policy requires models that explicitly account for production networks. Ignoring global input-output linkages systematically underestimates output losses and overstates inflation.
Second, monetary policy cannot be separated from trade policy. Tariffs reshape the inflation-output trade-off, and central banks must account for network-driven inflation persistence. Foreign monetary policy also matters: exchange-rate stabilisation elsewhere changes US output and consumption through foreign import demand and pass-through.
Third, trade policy in a large economy is a global macroeconomic shock. Even absent retaliation, tariffs transmit stagflationary pressures worldwide through supply chains and financial channels. As tariffs remain a prominent policy tool, understanding their consequences in a networked world is essential — and models that abstract from global production networks risk misleading guidance precisely when policymakers need clarity most.
Source : VOXeu
