In a world of trade tensions, what do tariffs really do?

Trade policy tensions are escalating fast. In recent months, several large economies have announced or implemented sweeping new tariffs, reviving a policy tool that many thought to have been largely relegated to the past. These developments have sparked a flurry of political commentary – but behind the headlines, there exists a body of economic research that helps to make sense of what tariffs actually do.

At their core, tariffs are simple: they raise the domestic price of imported goods. But their effects ripple through the economy in complex ways – altering prices, wages, exchange rates and trade patterns. As governments revisit this powerful lever, understanding the economic mechanisms at play has never been more important.

At the most basic level, a tariff is a tax on imported products. It drives a wedge between the world price and the domestic price. For instance, if a 10 per cent tariff is imposed on a product with a world price of US$ 100, the domestic price becomes US$ 110. The difference – US$ 10 – is collected as tariff revenue, which the government can use to finance its expenditures.

Tariffs can also affect the world price of a product, particularly when they are imposed by a large economy. The logic is that higher domestic prices reduce domestic demand, which in turn lowers world demand, and thus world prices. In our example, the world price might fall to $95 after the tariff is imposed, resulting in a domestic price of $104.50. In this case, part of the tariff is effectively paid by foreign producers.

This cost-shifting creates incentives for large economies to unilaterally impose tariffs. However, this so-called optimal tariff argument overlooks the possibility of retaliation. If country A imposes tariffs on country B, country B has an incentive to respond in kind. The end result is a trade war that leaves both sides worse off.

This logic underpins the leading theory of trade negotiations. If all economies attempt to benefit at each other’s expense, everyone ends up worse off – and this creates incentives for cooperative trade policymaking. The economics literature on trade policy has shown that the core WTO principles of reciprocity and non-discrimination are effective tools for escaping the logic of mutually harmful tariffs (Bagwell and Staiger, 2002).

The extent to which tariffs pass through to consumer prices is ultimately an empirical question. Evidence from the initial wave of US tariffs on China suggests full pass-through to US consumers (Amiti et al. 2019; Fajgelbaum et al. 2019). However, these studies focus on short-term effects and use methodologies that cannot fully account for broader macroeconomic adjustments. Standard quantitative trade models typically predict at least some cost-shifting to foreign producers.

A broader question is how tariffs affect inflation. When a country imposes a tariff, it causes a one-off increase in the domestic price level, but this does not necessarily translate into sustained inflation. One channel through which a tariff could lead to persistent inflation is a wage–price spiral, which is similar to what can happen with other supply shocks.

Tariffs do not just affect imports – they also affect exports. One direct channel is through higher prices for intermediate goods, which undermine the competitiveness of exporting firms; but broader general equilibrium effects are also important. Tariffs allow import-competing sectors to expand, which draws resources – such as labour, capital and land – away from other sectors, including exporting sectors.

This process operates through changes in the real exchange rate, which measures domestic prices relative to foreign prices, adjusted for the nominal exchange rate. As import-competing sectors expand, they demand more workers, which pushes up wages across the economy. Higher wages raise production costs for exporting firms, making them less competitive in international markets. The result is an appreciation of the real exchange rate, which makes exports relatively more expensive abroad.

A related question is what happens to the nominal exchange rate. One channel is direct: tariffs reduce import demand, and hence the demand for foreign currency, leading to an appreciation of the domestic currency. Another channel is indirect: tariffs may lead markets to anticipate tighter monetary policy to counter inflation, which can also cause the domestic currency to appreciate. For trade effects, what ultimately matters is the change in the real exchange rate; whether this occurs through adjustments in wages, domestic prices, or the nominal exchange rate is of secondary importance.

There is, thus, a trade-off between the inflationary and competitiveness effects of tariffs. If the exchange rate appreciates strongly, domestic prices rise little, but competitiveness suffers significantly. If it appreciates only slightly, domestic prices rise more, but competitiveness is less affected. Either way, tariffs impose economic costs.

A topical question is whether tariffs affect trade imbalances. The answer depends on whether one considers aggregate, bilateral or sectoral imbalances. Aggregate trade imbalances reflect the gap between national saving and national investment – a basic accounting identity. The logic is analogous to household finance: if a household (country) saves, it must earn (export) more than it spends (imports).

To improve the aggregate trade balance, tariffs would need to increase national saving or reduce investment, which is a possibility. For instance, households might delay consumption if they expect tariffs to be temporary, thereby raising saving. Alternatively, tariffs could reduce investment by increasing the cost of capital goods, or by creating policy uncertainty, leading firms to postpone spending.

However, most economists expect tariffs to have only limited effects on aggregate imbalances. Macroeconomic fundamentals – such as fiscal policy or the household savings rate – play a more dominant role. This view is supported by empirical studies that have found little impact of tariffs on aggregate trade balances so far (Furceri et al. 2022).

Tariffs can, however, affect bilateral trade balances by altering relative prices. It is entirely possible for country A to run a deficit with country B, B with C, and C with A – without any of them having an aggregate trade imbalance.

Tariffs can also affect sectoral trade balances. For example, higher tariffs on goods imports tend to improve the goods trade balance by discouraging imports through higher domestic prices, while worsening the services trade balance by reducing services exports through an appreciation of the real exchange rate.

As tariffs return to the trade policy agenda, it is worth recalling what economics has long understood: tariffs are not just a tool for raising revenue or protecting domestic industries – they are a policy lever with wide-ranging, and often unintended, consequences. Their appeal in the short term can obscure longer-term costs to inflation, competitiveness and international cooperation. In a world of growing trade tensions, a clear-eyed view of those trade-offs is more important than ever.