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Presentation by Ludovica Ambrosino, PhD student at LBS and Silvana Tenreyro at the LSE on how geopolitically driven trade fragmentation affects inflation and monetary policy. Context: post-war trade openness has plateaued since the Global Financial Crisis (GFC); a fragmentation index by Jesus Fernandez-Villaverde and his co-authors shows steady increases post-GFC with spikes around the pandemic and the war in Ukraine. Fragmentation implies trade realignment toward “friend-shoring” rather than a fall in openness, raising imported goods prices and lowering real incomes for many countries.

Research questions and preview findings

• Will fragmentation lead to a high inflation environment? Answer: it depends on the timing and nature of fragmentation and on demand responses. Even with a firm nominal anchor, fragmentation can produce higher inflationary pressures temporarily.
• Monetary policy response to keep CPI (Consumer Price Index) at target and the behavior of r star (natural rate of interest): it depends on how demand reacts to permanently lower incomes. A sharp demand fall can lower R star.
• Preview: Front-loaded fragmentation can cause a stagflationary spike (higher CPI inflation with lower output). Gradual, anticipated fragmentation can produce stagnation (lower real incomes, domestic disinflationary forces, and lower natural rates). A tradables TFP (Total Factor Productivity) deterioration generates an initial CPI rise followed by a persistent decline; policy must tighten then loosen.

Model setup (small open New Keynesian economy)

• Households: two types.
  • Unconstrained: maximize utility over consumption, labor, and assets; trade domestic and foreign riskless bonds subject to a quadratic cost of changing real asset positions; receive labor income and firm profits.
  • Constrained (hand-to-mouth): no financial market access; supply labor and consume all disposable income each period.
• Firms and sectors:
  • Non-tradables: monopolistic competition and sticky prices; Cobb–Douglas production using domestic labor and imported inputs (e.g., energy); takes input prices as given.
  • Tradables: internationally competitive, prices set internationally; production uses labor.
• Price aggregation: CPI is a nested composite of tradables and non-tradables; tradables comprise home and foreign goods; non-tradables aggregate differentiated varieties. The foreign tradables price PFT is the import-price shock.
• Consumption aggregator: CES between tradables and non-tradables; tradables are CES between home and foreign. Home-bias parameter (1 − data) governs openness; a higher foreign share implies greater exposure.
• Policy: monetary authority targets CPI, responding to deviations from target.
• Calibration notes: utility deviates from log with unitary elasticity of substitution (extensions consider varying elasticities). The home economy takes rest-of-world dynamics as exogenous.

Bird’s-eye propagation and trade channels

• Both household types supply labor to domestic production; unconstrained households can borrow domestically and from abroad.
• Import price shocks affect:
  • Imported inputs in non-tradables production (e.g., energy costs).
  • Foreign tradables in the household consumption basket (alongside home tradables and non-tradables).

Shock scenarios and results (RANK: Representative Agent New Keynesian)

• Gradual, anticipated rise in foreign prices (PFT):
  • Foreign price level rises gradually and stabilizes higher. Anticipation lowers consumption; labor demand falls; labor supply increases.
  • Natural rate of interest declines with weaker demand.
  • Imported inflation spikes, but the fall in non-tradables inflation dominates; aggregate CPI disinflates over time before recovering. Stagnation: lower activity and lower inflation; policy has room to loosen to bring CPI back to target.
• Front-loaded, permanent increase in foreign prices:
  • Immediate jump in foreign prices; consumption and real wages fall; natural rate does not change materially.
  • CPI inflation spikes despite falling domestic/non-tradables inflation; the spike is short-lived.
  • Stagflation: higher CPI with lower activity; a sharper policy trade-off emerges.
• Gradual deterioration in domestic tradables TFP:
  • Consumption falls; natural rate falls.
  • CPI inflation rises initially, then declines persistently.
  • Policy needs to tighten initially and then loosen subsequently.

Introducing hand-to-mouth households (TANK: Two-Agent New Keynesian)

• Motivation: constrained households cannot smooth against anticipated import price increases, dampening anticipation effects.
• Demand spillovers: as unconstrained households cut consumption, constrained households’ labor income falls, amplifying their consumption decline.
• Outcomes: slightly larger consumption fall and stronger reallocation from non-tradables to tradables; inflation and natural rate dynamics are similar to RANK across all scenarios.
  • Gradual import price rise: still stagnation (lower inflation, activity, and natural rate).
  • Front-loaded import price jump: still stagflation (higher CPI with lower activity).
  • Tradables TFP shock: similar qualitative results to RANK.

Role of trade openness

• Greater openness raises exposure to foreign price shocks, leading to larger declines in consumption and real wages, and stronger reallocation toward home tradables.
• Gradual import price rise: more open economies experience larger falls in domestic inflation components and in the natural rate; deeper stagnation.
• Front-loaded import price jump: the policy trade-off is more difficult in more open economies (higher CPI inflation despite weaker demand).
• Domestic tradables TFP shock: openness matters less for the shock’s origin, but being open helps diversify away from the affected home tradables sector, making output effects less adverse. Consumption in more open economies can fall more due to the distribution of profits (unconstrained households take a bigger hit).

Monetary policy implications

• With a credible nominal anchor, fragmentation need not cause persistently higher inflation, though it can raise inflationary pressures temporarily.
• The natural rate (R star) declines when fragmentation or TFP shocks depress demand and real incomes.
• Policy stance by scenario: ease under gradual, anticipated fragmentation; tighten under front-loaded import price jumps; tighten-then-loosen under domestic tradables TFP deterioration.