Trade War Effects on Foreign Exchange

The US-China trade war has been one of the more influential economic events over the past 2 years and has played a big part in defining President Trump's performance as leader of the US. Peterson Institute for International Economics recently reviewed how his tariffs have impacted exchange rates in the dollar and renminbi markets. The analysis begins with the theoretical assumption that tariffs should lead to appreciation in the imposer's currency while the currency of the imposed will depreciation. Of course, the trade war included retaliatory tariffs, so the dynamics have been analyzed both ways.

The main theoretical framework is built with the initial assumption that the imposing country is at full employment. After the tariff is imposed, inflationary forces are increased by demand for labor and domestic currency. With a central bank that wants to keep monitor inflation, interest rates increase and the domestic currency appreciates. The model applies in the opposite way as well. The country that has tariffs imposed on their exports experiences a demand shock for their goods, deflationary pressures increase, and a central bank would lower interest rates producing a depreciative effect on the currency.

In 2018, the paper points out that the US imposed an average of 6.8 percent of tariffs on China after considering all blocks of tariffs are considered. Based on the model described above with understood assumptions made about domestic good substitution for foreign goods, those tariffs should have resulted in a 0.37 percent appreciation of the dollar and adding in the effects of solar panel, washing machine, steel, and aluminum tariffs would bring that total to 0.51 percent.

However, piece the full picture together (effects of tariffs going both ways on both countries), and the model suggests both currencies (dollar and renminbi) would experience a net depreciation. These results point out that based on the assumptions that were made about the US and China, the tariffs that were put in place should have a net decrease in demand in both economies, one reason why many think the trade war was ill-advised. However, the results in the table above are starkly different from what happened. In 2018, the renminbi depreciated 5.5 percent and the dollar appreciated 7.9 percent (according to Federal Reserve Broad Index).

The paper concludes with the admission that the theoretical framework for modeling tariff's effects on foreign exchange just didn't explain the movements of the dollar and renminbi in 2018. There was only a slight connection between the renminbi's 5.5 percent depreciation and the 1.1 depreciation that was modelled. From a broader view though, the model does communicate the idea that China would be more impacted by the trade war than the US. Of course, foreign exchange is affected by many factors, so the strong 7.9 percent dollar appreciation must be explained by other forces. Overall, if this administration entered the trade war thinking that the US would remain the most resilient, it appears that can be claimed as one of the successes of the protectionist policy.