Job Market Paper

Abstract: How—and by how much—do tariffs rebalance the current account? With the return of tariffs and trade wars, the question is pressing. I develop a model in which oligopolistic firms set markups strategically and reshape market structure through entry and exit, while households face imperfect risk sharing in financial markets. Tariffs generate an income gain through real exchange rate appreciation and tariff revenue, but the income gain translates only partly into household spending, thereby reducing the deficit. In addition, I show that a higher aggregate trade elasticity, which summarizes the sensitivity of imports to relative price changes, leads to a smaller income gain from real exchange rate appreciation. By changing the aggregate trade elasticity, industrial market structure alters the income gain through firm participation and markup adjustment. Moreover, imperfect risk sharing prompts households to spend a larger share of the income gain, which weakens deficit reduction. Calibrating the model to match firm-level tariff responses and the production network, I find that raising US tariffs to 30% on China and 10% on other foreign regions reduces the US trade deficit by 12.4%. A counterfactual that shuts down changes in firm participation and markups overstates the deficit reduction by roughly one-quarter. Finally, complete financial markets with perfect risk sharing approximately double the deficit reduction, from 12.4% to 27.6%.