Optimal trade policy with trade imbalances

Abstract

Optimal trade and capital control policies are characterized under a dynamic model with endogenous trade imbalances. In the absence of capital controls, optimal trade protection is counter-cyclical. Optimal use of capital controls, however, dampens the time-variation of optimal trade taxes. Generally, trade imbalances are not predictive of optimal policy. However, optimal trade policy and equilibrium trade imbalances move together when a country grows consistently faster or slower than the rest of the world. Quantifying the model for the U.S. economy shows that welfare gains from optimal policy are largely due to static terms-of-trade effects, implying that gains from time-varying tariffs or capital controls are small.