Exchange rate pass-through and the effects of tariffs on economic performance and welfare

We develop a stochastic two-country general equilibrium model, where prices are determined under conditions of monopolistic competition to examine the macroeconomic and welfare effects of tariffs on the world economy under alternative nominal rigidities: producer-currency pricing (PCP) and local-currency pricing (LCP) where the exchange rate pass-through is absent. We find that the significance of export pricing for the effects of tariffs depends critically upon whether tariffs are anticipated or unanticipated. In the former case both PCP and LCP yield the same outcome as do perfectly flexible prices, although the mechanism whereby this is achieved is different. In the latter case, the effects of unanticipated permanent tariffs are highly sensitive to the pricing scheme adopted by exporters, leading to a wide range of conflicting outcomes, involving tradeoffs among key parameters. (C) 2012 Elsevier Ltd. All rights reserved.