Summary:
Trade friction between China and the United States (US) broke out in early 2018. We can foresee that with the gradual improvement of China's international economic status, Sino-US economic and trade relations will continue to be affected by various forms of friction and conflict. Moreover, it is likely that such frictions and conflicts will exist cyclically in the long run, which will eventually have significant and profound impacts on China's macro-economy. Therefore, it is necessary to analyze the following questions in depth: how will trade frictions affect China's macro-economy？ To what extent can China open up its economy? According to international trade theory, a country can impose tariffs to improve its terms of trade and promote net export growth. Therefore, tariff measures are often used as the most direct policy tool when trade frictions occur between two countries. This article introduces tariff shocks, foreign exchange risk premiums, and monetary policy cost channels into a two-country open economy dynamic stochastic general equilibrium model to study the macroeconomic fluctuations caused by trade frictions and analyze relevant policy options for the economic opening of markets. This article decomposes the real exchange rate fluctuations caused by tariff shocks into “direct effects” and “indirect effects” and clarifies the transmission channels and theoretical mechanisms through which tariff shocks affect the terms of trade and the real exchange rate. First, the log-linearization of the real exchange rate equation shows that an increase in tariffs directly triggers the devaluation of the domestic currency. However, these exchange rate changes cannot fully offset the price distortion caused by tariff shocks. Second, after expressing the terms of trade as an equation of the relative output levels of the two countries, tariffs, and foreign exchange risk premiums, we find that tariff shocks deteriorate the terms of trade, which triggers the appreciation of the domestic currency. Therefore, tariff shocks affect the real exchange rate through direct and indirect channels. The results of impulse response analysis show that tariff shocks change the terms of trade and the real exchange rate. Under the current status of China's trade openness, foreign tariffs will not only deteriorate the country's terms of trade, leading to a decline in exports and output, but will also depreciate the country's exchange rate, leading to an increase in exports and output. Overall, for the macro-economy, tariff shocks will induce a minor increase in domestic output and a decline in home inflation, as well as a decline in foreign output levels and an increase in foreign inflation. Moreover, if the domestic government strengthens its control over cross-border capital flows during trade frictions, the terms of trade will deteriorate and cause the real exchange rate to appreciate, which will negatively affect exports and output. A loose monetary policy can directly stimulate output growth and, simultaneously, indirectly increase domestic economic output by depreciating the exchange rate and improving the terms of trade. The results of economic welfare analysis suggest that the government's choice of trade openness and capital account openness significantly affect macroeconomic fluctuations. First, a moderate increase in domestic trade openness leads to a slight increase in economic welfare losses, while the foreign country faces greater welfare losses; an excessive increase in domestic trade openness leads to a sharp increase in domestic welfare losses, which reach a value greater than the welfare losses incurred by the foreign country. Second, in trade frictions, a moderate relaxation of capital controls improves the terms of trade, which depreciates the real exchange rate and increases output. Finally, an increase in foreign tariffs will trigger the devaluation of the domestic currency. The moderate depreciation of the domestic currency helps hedge against the negative impact of tariffs, increase exports, and boost domestic economic output. In conclusion, in the face of the trade frictions, the domestic government should adhere to the principle of increasing trade openness within an appropriate scope and steadily promote capital account liberalization to avoid substantial economic welfare losses. In addition, implementing a loose monetary policy and relaxing the exchange rate daily trading band can help mitigate the negative impacts of trade frictions.
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