Optimal Monetary Responses to Tariffs According to HANK

Abstract

I characterize optimal monetary responses to tariff shocks in an open economy Heterogeneous Agent New Keynesian (HANK) model. I show that a planner has a novel motive to cut or raise nominal rates in such a model depending on how tariff revenue is spent and how the planner values any redistribution that revenue induces, they may desire higher (lower) foreign consumption and tariff revenue, pushing them towards rate cuts (hikes). Unlike similar findings in RANK models, this fiscal externality motive does not always push towards rate cuts. When tariff revenue targets high marginal value households, such as with lump sum transfers, the planner cuts rates. If tariff revenue is spent in distributionally neutral or negative ways, such as paying down outstanding debt, the planner expands less or raises rates, as they do not desire additional tariff revenue. I also highlight how the initial level of redistribution and the planner’s attitude towards further redistribution shape policy.