Trade Costs and Inflation Dynamics

We explore how shocks to trade costs affect inflation dynamics in the global economy. We exploit bilateral trade flows of final and intermediate goods together with the structure of static trade models that deliver gravity equations to identify exogenous changes in trade costs between countries. We then use a local projections approach to assess the effects of trade cost shocks on consumer price (CPI) inflation. Higher trade costs of final goods lead to large but short-lived increases in inflation, while increases in trade costs of intermediate goods generate small but persistent increases in inflation. We develop a multi-country New Keynesian model featuring trade in final and intermediate goods and show that it can replicate the inflation responses we identify in the data. We estimate the model using historical data and use it to explore the drivers of U.S. inflation in the aftermath of the COVID-19 pandemic. We find that trade costs account for one percentage point of additional inflation in 2022 and the bulk of inflationary pressures in 2023.