Monetary Policy And Trade Wars

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by: American Institute of Economic Research

By Nicolás Cachanosky

It is difficult enough under normal economic conditions for policymakers to efficiently manage the money supply. To add to the difficulty, policymakers now need to make their decisions in the context of a potential trade war. The many unintended consequences of a trade war are very hard, if not impossible, to predict.

A particular challenge for policymakers is that monetary policy and fiscal policy - and a trade war can be thought of as fiscal policy - can either boost or offset each other, depending on the monetary regime followed by a central bank, as discussed on this blog (here, here, and here).

In the case of a fixed exchange rate, an expansion (or contraction) of fiscal policy needs to be accommodated by monetary policy. As long as there is free capital mobility, a central bank cannot have both a fixed exchange rate and policy autonomy. Even if the exchange rate is free to float, a fiscal policy that has a significant effect on the exchange rate may trigger a monetary policy reaction intended to avoid too much appreciation or depreciation.

By changing the context in which monetary policy is decided, a trade war increases the complexity of monetary policy. Central bankers cannot know for sure whether their policies are going to be magnified or offset by domestic fiscal policy. Nor can they know how foreign countries will react to the domestic trade initiative. What will foreigners' fiscal policy be? What will foreign central banks' reactions be?

For some years now, the United States has turned its back on economic rationality. A trade war would not only make the United States less productive, it would also make monetary policy more difficult.

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