The price of division: sticky prices and monetary policy in a fragmenting world

Summary

We develop a new model to analyze trade fragmentation scenarios, simulating an increase in trade restrictions between a Western bloc and an Eastern bloc of countries while leaving trade restrictions unchanged vis-à-vis a neutral bloc. We find that trade fragmentation lowers GDP and raises inflation in both East and West while the neutral bloc benefits from trade diversion. The Eastern bloc is hit harder than the Western bloc because it depends more on international trade.

Highlights

A new model for fragmentation analysis 
Our model combines features of the macroeconomic literature (like nominal rigidities and dynamic adjustment) and trade literature (like endogenous firm entry and trade costs) to analyze trade fragmentation scenarios. 

Trade fragmentation lowers GDP 
Trade fragmentation lowers the efficiency of global production and, as a consequence, reduces the GDP of all involved countries. Neutral countries can benefit somewhat from trade diversion. 

Trade fragmentation raises inflation 
Trade fragmentation raises the cost of imported foreign goods, thereby driving up domestic inflation. If this inflation feeds into higher wages, it can be very persistent