Yves here. The authors featured below have crafted a sophisticated model assessing the effects of tariffs, which goes beyond the traditional, often overly simplistic methods. Their incorporation of production networks and other critical variables indicates that even temporary tariffs can inflict considerable and enduring harm.
By Sebnem Kalemli-Ozcan, Schreiber Family Professor of Economics at Brown University; Can Soylu, Brown University; and Muhammed A. Yıldırım, Assistant Professor of Economics at Koc University. Originally published at VoxEU
The resurgence of tariffs as tools for economic and geopolitical strategy has prompted an exploration of their short- and medium-term macroeconomic implications, which remain inadequately understood. This column presents a new framework that weaves global production networks into a standard open-economy model. It reveals that tariffs function as simultaneous demand and supply shocks, with significant macroeconomic effects hinging on production networks, price rigidities, and monetary policy responses both domestically and internationally. By integrating these elements, even temporary tariffs can lead to persistent inflation, substantial output losses, and international spillovers in the absence of retaliatory measures.
Tariffs have re-emerged as critical tools in economic and geopolitical arenas. Recent analyses on VoxEU detail how the 2025 escalation in U.S. tariffs has disrupted trade flows, supply chains, and the broader global economic landscape (Conteduca et al. 2025, Cerdeiro et al. 2025). Traditional trade models often focus on long-term welfare and terms-of-trade effects under assumptions of flexible pricing. However, the short- and medium-term effects of tariffs in economies characterized by nominal rigidities, production networks, and financial frictions are less clearly understood. The interconnectedness of modern economies through global production and financial networks—coupled with slow price adjustments, especially in the service sector—means that trade distortions can filter through firms, sectors, and countries in ways that standard open-economy models often overlook.
This column outlines a new model that integrates global production networks into the standard New Keynesian open-economy framework utilized by central banks, accounting for incomplete financial markets (Kalemli-Özcan et al. 2025). The core insight is that tariffs simultaneously act as demand and supply shocks, with their macroeconomic effects critically dependent on production networks, price rigidities, and monetary policy reactions both domestically and abroad. By including these elements, even transient tariffs can trigger enduring inflation, extensive output losses, and global ramifications without retaliation.
The model encompasses a broad category of open-economy models within five key 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 generates two important analytical tools. The first is a risk-sharing wedge: in incomplete markets, tariffs redistribute wealth across nations by altering terms of trade, exchange rates, and net foreign asset positions. The second is a New Keynesian open economy propagation matrix—a dynamic structure akin to a Leontief inverse—that captures how cost distortions induced by tariffs propagate through global production networks over time. Together, these tools offer three essential insights:
- Inflation persistence arises from the granularity of networks: in a multi-sector framework, lagged sector-specific cost distortions impact current inflation, leading to prolonged and sluggish responses.
- Overall, tariffs tend to induce stagflation in a global equilibrium: the direct pass-through and increased costs of imported inputs elevate consumer and producer prices, while rigid prices and complementary inputs hinder immediate output adjustments.
- Exchange rates and consumption are influenced by wealth transfers: without uncertainty and symmetric retaliation, tariffs can lead to a dollar appreciation by improving U.S. terms of trade, though uncertainty (financial channel) or the threat of retaliation (expectations channel) can counter this and lead to dollar depreciation.
The Devil is in the Details
Traditional trade models view tariffs merely as import taxes that shift consumption towards domestic goods. This perspective oversimplifies the issue, often portraying short-term effects as benign or even expansionary for larger countries able to achieve high levels of import substitution. It overlooks the fact that modern production heavily relies on imported intermediate inputs that complement labor, and that price adjustments occur slowly and vary significantly across sectors.
When businesses procure inputs on a global scale, tariffs directly drive up marginal costs. These increased costs ripple through production networks to sectors that may not be directly involved in international trade, affecting even non-tradables such as services. Consequently, tariffs skew both consumption and production choices, acting as simultaneous demand and supply shocks. The combined influence of these shocks—impacting terms of trade, exchange rates, and wealth valuations—determines how wealth is transferred between countries.
Three critical channels emerge from this analysis. On the demand side, rising consumer prices redirect spending towards domestic goods in the short run and towards future periods without tariffs in the long run. On the supply side, increased costs of imported inputs diminish output and measured productivity. Furthermore, tariffs cause a relative shift in wealth among nations, influencing consumption patterns, exchange rates, and current accounts. The relative efficacy of these channels is determined by substitution elasticities, the global input-output architecture, trade imbalances, and varying monetary policy responses.
Why Production Networks Matter for Inflation Dynamics
Production networks dramatically influence inflation dynamics when nominal rigidities are at play. Different sectors exhibit varied price-setting behaviors and occupy distinct positions within the network. A tariff that raises costs in upstream sectors—such as energy, basic materials, and essential manufacturing inputs—causes increases that cascade through the network, ultimately affecting downstream prices over time.
With staggered price adjustments, this propagation gives rise to inflation persistence. In models focused on a single sector, a temporary cost shock generally results in a one-off inflation spike. However, in multi-sector models with complex network interactions, past sectoral cost distortions contribute to current inflation—a mechanism described by the New Keynesian open economy propagation matrix. Therefore, even short-term tariffs can trigger extended inflationary pressures, forcing monetary policy to navigate a tighter inflation-output trade-off: controlling inflation requires more prolonged tightening, which in turn exacerbates output losses. Instead of arising from an external supply shock, stagflation can be viewed 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 variations that exclude input-output linkages, retailers, price stickiness, or open-economy spillovers; the bottom row compares differing monetary policy rules. Ignoring production networks and modeling the economy as a ‘small open economy’ tends to exaggerate inflation responses while underestimating output losses.
Figure 1 demonstrates the importance of the network channel. The top row examines the model’s features one at a time, maintaining the tariff scenario as established by the U.S. as of March 2026. Eliminating the global input-output structure (‘No IO’) or treating the U.S. as a small open economy (‘SOE’) increases the inflation response and minimizes the output decline because the supply-shock effects of tariffs are negated once imported intermediates are excluded from domestic marginal costs. Removing the importing sector (‘No Retailers’) maximizes inflation due to complete and instantaneous pass-through of tariffs to consumer prices, adversely impacting consumption responses. Holding expenditure shares constant (‘All Cobb-Douglas’) enhances terms-of-trade gains, consequently increasing U.S. consumption. Models that overlook production networks systematically inflate inflation projections and downplay the output costs of tariffs, failing to account for the gradual propagation effects across sectors, countries, and time.
The bottom row adjusts the model while keeping its features static, varying the monetary policy rules. U.S. inflation displays the most variation under ‘Fixed Nominal Demand’ and an active U.S. Taylor rule, where the Federal Reserve reacts to tariff-induced CPI fluctuations rather than disregarding them. Both strategies lead the central bank to accommodate less of the price increase, reducing inflation at the expense of weaker output. Additionally, foreign policy decisions exert significant influence. A euro area real-rate rule stabilizing consumption undermines the euro, reduces euro area imports from the U.S., and results in a persistent decline in U.S. output. Conversely, a stronger dollar fosters a more sustained increase in U.S. consumption. China’s approach to exchange-rate stabilization operates through a distinct channel, modifying the dollar pass-through dynamics. The domestic outcomes of tariffs hinge not only on responses from the home central bank but also on the strategies employed by major trading partners.
Exchange Rates, Incomplete Markets, and Wealth Transfers
Tariffs impact exchange rates and international financial movements significantly. In incomplete market environments, exchange rates equilibrate both goods and asset markets. Thus, they function not merely as relative price adjustments but also facilitate wealth transfers among countries ignited by trade policies.
In a one-sector model, when a dominant country imposes unilateral tariffs, its currency generally appreciates: expenditure shifts toward domestic products, which the tariff renders relatively scarce and more valuable. This enhances home terms of trade and transfers wealth towards the country imposing the tariff; in our terminology, the risk-sharing wedge becomes negative.
However, production networks can reverse the sign of the wedge and the currency response. When tariffs target goods that serve as upstream inputs for domestic firms, the tariffs inflate local production costs and reduce downstream output availability. For example, imposing tariffs on imported semiconductors used in chip production would increase domestic chip prices; however, if foreign companies rely on these chips, the shock transcends borders. When input complementarities are substantial, this network-induced scarcity effect may outweigh the expenditure-switching effect, negatively impacting home terms of trade. Consequently, the risk-sharing wedge turns positive: tariffs transfer wealth away from the imposing country, resulting in lower domestic consumption.
The Role of Expectations and Tariff Threats
Expectations represent a crucial but often neglected aspect of trade policy. We analyze reversed tariff threats: situations in which tariffs are announced, and agents anticipate their implementation along with retaliation, only for them to be rescinded before enactment. This scenario isolates the macroeconomic impact of mere announcements.
The repercussions are significant. Using previously established tariff rates, the reversed-threat scenario increases U.S. inflation by 0.34 percentage points immediately, while reducing consumption by 0.25%, enhancing real GDP by 0.27%, and depreciating the trade-weighted dollar by 2.66%. As the reversal is disclosed, exchange rates adjust promptly, but inflation, consumption, and output take multiple quarters to revert to their steady states.
The underlying mechanism is tied to expectations. Agents adjust their consumption and pricing strategies based on anticipated trade barriers, leading to immediate exchange rate responses that forecast expected changes in trade flows. Thus, tariff threats can create inflation, output fluctuations, and exchange rate adjustments even before any actual tariffs are enacted.
World Trade Rewired
Figure 2 depicts how the global trade network restructures over time. A significant trend is U.S. decoupling: trade between the U.S. and major blocs declines, particularly in transactions with China and the euro area. The only exception is a slight increase in euro area exports to the U.S. (+0.9%), attributed to less stringent tariff rates on euro area products. Beyond the U.S., the overall pattern reflects trade diversion rather than uniform reduction. Trade between the euro area and China, Mexico, and the rest of the world shows growth across most categories, while several non-U.S. trading pairs—especially China-Canada and Mexico with the rest of the world—experience notable positive changes. Even bilateral trade flows not directly involving the country imposing tariffs get reshaped through the global production network, illustrating how a tariff shock in a large economy reverberates as a global macroeconomic disturbance within 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 U.S. 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 represent predicted flows that decrease relative to the pre-tariff baseline, while thick red lines indicate flows that increase.
Policy Implications
The findings present several key implications for policymakers.
First, assessing trade policy requires models that explicitly incorporate production networks. Neglecting global input-output linkages consistently underestimates potential output losses and exaggerates inflation effects.
Second, monetary policy must be considered alongside trade policy. Tariffs reshape the trade-off between inflation and output, necessitating that central banks accommodate for the inflation persistence driven by network intricacies. Furthermore, foreign monetary policies play a crucial role: stability in exchange rates elsewhere can influence U.S. output and consumption through alterations in foreign demand and pass-through effects.
Third, trade policies enacted by significant economies function as global macroeconomic shocks. Even in the absence of retaliatory actions, tariffs generate stagflationary pressures that ripple through supply chains and financial networks worldwide. As tariffs continue to serve as a significant policy instrument, it is vital to grasp their ramifications within a networked context; models that overlook global production networks risk providing misleading insights, especially when clarity is most needed by policymakers.
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