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Trade Costs and Inflation Dynamics

Albert Queralto (FRB), Ricardo Reyes-Heroles (FRB), and Mikaël Scaramucci (FRB)


We explore how shocks to trade costs affect inflation dynamics in a global economy. We identify trade costs by exploiting bilateral trade flows for final and intermediate goods and the structure of static trade models that deliver structural gravity equations. We then use a local projections approach to assess the effects of estimated trade cost shocks on countries’ consumer price (CPI) inflation and other macroeconomic variables. Higher trade costs lead to increases in inflation and dampen economic activity. We propose a multi-country New-Keynesian model featuring international trade in final and intermediate goods that can replicate the macroeconomic responses we identify in the data. We show that a global increase in trade costs can lead to a global surge in inflation. We also show that the degree of trade integration and the elasticity of substitution between production inputs play an important role in shaping the response of inflation to trade cost shocks. We use the model to explore counterfactual paths of U.S. inflation in the aftermath of the COVID-19 pandemic.