Protectionism and the Business Cycle

We study the consequences of protectionism for economic fluctuations. First, using data on tariffs and non-tariffs barriers, we present fresh evidence on the dynamic effects of an increase in trade barriers. Estimates from country-level and panel VARs show that protectionism acts as a supply shock, causing output to fall and inflation to rise in the short run. Second, we study the channels through which protectionism affects aggregate fluctuations in a small-open economy model that features firm heterogeneity, endogenous tradability, and nominal rigidity. Higher trade barriers reduce consumers' real income and reallocate market shares toward relatively more inefficient domestic firms. Nominal interest rates increase to stabilize domestic inflation. These contractionary effects more than offset the increase in production induced by expenditure switching toward domestic goods. Consistent with the empirical analysis, protectionism has at best a small positive effect on the trade balance, implying that raising trade barriers is not an effective tool to promote rebalancing of external accounts. Finally, we find that the short-run costs of protectionism can be larger in economic downturns, even when monetary policy is constrained by the zero lower bound on nominal interest rates.