Abstract
We explore how shocks to trade costs affect inflation dynamics in a global economy. We exploit bilateral trade flows of final and intermediate goods together with the structure of static trade models that deliver gravity equations to identify exogenous changes in countries’ trade costs. We then use a local projections approach to assess the effects of trade cost shocks on countries’ consumer price (CPI) inflation. Higher trade costs of final goods lead to large but short-lived increases in inflation, while increases in trade costs of intermediate goods generate small but relatively more persistent increases in inflation. We propose a multi-country New Keynesian model featuring trade in final and intermediate goods and show that it can replicate the inflation responses we identify in the data. We estimate the model using historical data and use it explore the drivers of U.S. inflation in the aftermath of the COVID-19 pandemic. We find that trade costs explain about one percentage point of additional inflation in 2022 and contributed to the bulk of inflationary pressures in 2023.