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So in our paper, we are trying to capture the trade-off that an increase in tariffs is going to generate for a central bank. And the problem is that when you have higher tariffs for a given monetary policy, inflation is going to be higher and economic activity is going to be lower. So this is the hardest problem for a central bank, because if they could try to fight inflation, but this is gonna be at the cost of increasing the contraction of the economy. Or they can choose to fight the contraction, but this is gonna be at the cost of higher prices. And in an environment where tariffs are already increasing inflation, this is gonna be particularly hard.
Cost-push shocks are the technical term to describe exactly what I just mentioned. So a shock, like an increase in tariffs, that is going to generate at the same time higher inflation and lower economic activity. And so a cost-push shock is the worst shock for a central bank because this is going to create a conflict between the two objectives of the central bank, which are keeping inflation low and stable and, at the same time, spurring economic growth.
The problem for a central bank is that the central bank has only one tool to affect the economy. And the tool is changing the spending and the borrowing level of people in the economy by changing the interest rate. So they can choose to, for example, reduce the interest rate to stimulate demand. And this is going to generate higher economic activity, but it’s going to be at the cost of higher prices. And this is exactly the problem when we have higher tariffs.
And this is exactly the environment where we are living right now. We are starting to see now in the summer of 2025, from the data of prices and of the liberal market, that the Federal Reserve is going to face a difficult dilemma.
So to study this issue, we use a simple macroeconomic model with nominal rigidities and the important addition of intermediate goods that can be purchased abroad. And this is particularly important because tariffs are distortionally exacted in the use of these intermediate goods. This allows us to kind of connect the micro standard view that tariffs are distortionary taxes with the common macro view that tariffs generate inflation.
Our model implies that central bankers should accept some degree of inflation. And this is because tariffs are distortionary in the use of intermediate goods, and in particular, tariffs are reducing the incentive for businesses to purchase intermediate goods from abroad. But if the fundamentals of the economy do not change, it would be optimal, actually, to keep buying those intermediate goods. So a way in which the central bank can contrast this distortion is actually by stimulating aggregate demand.
The problem is that if central banks stimulate aggregate demand forever or for a persistent period of time, then this can make inflation entrenched in the economy. So the optimal thing to do for central bankers is to run the economy hot, but just for a short amount of time in the short term.
I wanna clarify that our model is based on the assumption that the central bank has the reputation to make promises about future course of action. So we have to be careful that if the central bank loses its independence, then the optimal policy may be dangerous because it may send the wrong signal about the desire to keep inflation low and stable in the future. So in this case, if the central bank loses its independence, the central bank may need to raise interest rates in response to the increasing tariffs as soon as inflation rises, exactly to send a signal that they’re going to keep inflation under control.
