How the Fed Model Shows Tariffs Boost Growth
Tariffs can boost U.S. economic growth over the long term even when foreigners absorb just a tiny fraction of their cost, according to the Federal Reserve’s main economic model.
The Federal Reserve Board’s large-scale model, known as FRB/US, indicates that a broad 10 percent tariff on non-oil goods can leave real GDP about 0.28 percent higher after ten years if foreign producers absorb just over one percent of the total tariff bill. Business investment also ends up higher.
That is a striking result given the mainstream economics profession’s animosity toward tariffs. Economists at the Fed have devoted enormous attention to the costs of tariffs. Yet they’ve done almost no work exploring the fact that the Fed Board’s model shows tariffs adding to growth.
“What If” Scenarios for Economics
We discovered the results of the Fed’s model while investigating Harvard economist Jason Furman’s recently published simulations of “alternative histories.” These are pretty fun to play with, so we encourage you to check them out. You can see what happens under the Fed’s model if the 2009 stimulus had been larger or if the Biden administration’s American Rescue Plan had been smaller or if Putin had not invaded Ukraine. It’s like the old “What If” comic books that Marvel used to put out—but for econ nerds instead of comic nerds.
In his examination of alternative tariff histories, Furman uses the Fed’s model to examine a permanent 10 percent tariff on non-oil goods. His simulations show the American economy shrinking relative to where it would have been without tariffs. After ten years, real GDP is about 0.22 percent lower, and business investment is down 3.51 percent.
The main source of the lasting economic damage in Furman’s scenario is weaker investment. Because tariffs make imported machinery and equipment more expensive, businesses are discouraged from expanding. This leads to a lower level of investment which reduces the productive capacity of the U.S. economy and, eventually, results in lower growth and a smaller economy.
Part of the reason for this is that Furman’s simulations assign the entire tariff burden to American consumers and businesses. American households pay higher prices, U.S. companies absorb some costs through lower profits, and domestic businesses buying imported equipment face higher investment costs. Foreign suppliers don’t lower prices or otherwise bear any of the burden of the tariffs.
But the negative investment result also depends on a consequential change Furman makes to the Fed’s standard model.
When a business is deciding whether to expand, it considers both what new equipment costs and what it can earn from the additional production. Both weigh on the decision in opposite directions. More expensive machinery discourages investment while the expectation of higher selling prices encourages it.
To illustrate this, suppose an American manufacturer can charge more for its goods while the cost of adding production rises less. Expansion becomes more attractive. Looking only at the machine’s purchase price misses the other side of the calculation: the value of what that machine will produce.
The Fed’s model normally recognizes this relationship. Alongside interest rates, taxes, and depreciation, investment depends on the price of capital relative to the price businesses receive for their output.
Furman found that his tariff-related consumer-price increases, working through the standard equations, lowered the relative price of investment. Investment rose, and the ten-year GDP effect turned positive.
He regarded that response as something his tariff construction should prevent. It didn’t strike him as a plausible result. So he replaced the standard investment-price equation with one that holds the relevant relative price on its baseline path, apart from an added charge for tariffs on imported equipment. This is not some underhanded move on his part. He’s perfectly transparent about what he did and why.
The effect of Furman’s adjustment is to preserve the discouraging effect of more expensive equipment while suppressing a central channel through which higher domestic selling prices can encourage expansion. Tariffs are all costs and no benefit in his modified model.
Restoring the Gains from Higher Selling Prices
So we wondered what would happen if we restored the standard equation while keeping his equipment-tariff surcharge. Businesses still face the cost of tariffs on imported machinery. But now the model can also recognize the investment incentive created when domestic selling prices rise relative to capital costs (which is what the FRB/US model would do absent Furman’s manual intervention).
That single change works a dramatic transformation in the the results. Even with foreigners absorbing none of the tariff bill, ten-year GDP goes from about 0.22 percent below baseline to 0.27 percent above it. So the economy is larger. The investment decline shrinks from 3.51 percent to just 0.075 percent, still slightly negative but nowhere near what it is in Furman’s “What If” scenario.
In other words, almost the entire investment loss disappears before foreign suppliers contribute a penny. And the contribution to GDP becomes positive.
Then we let foreign equipment suppliers absorb four percent of the duties on their goods through lower pre-tariff prices. For each original dollar of equipment tariffs, foreign producers absorb four cents.
Not that this isn’t foreigners cutting prices by four percent or even paying four percent of all the tariffs. It’s just foreigners paying four percent of the tariffs on capital goods.
Since capital goods account for 29 percent of the tariff bill in Furman’s calculations, the foreign contribution amounts to just 1.16 percent of the total. So in our adjustment, Americans still bear nearly 99 percent of the initial bill. That’s almost certainly too high; but for the purposes of exploring the Fed’s model, we wanted to minimize the size of the foreign contribution.
With that small concession, ten-year GDP rises 0.282 percent above baseline, and investment moves slightly into positive territory at 0.016 percent above baseline. The important investment result is the reversal of a projected decline exceeding three percent.
The gains persist. After 30 years, GDP is about 0.21 percent higher and investment roughly 0.42 percent higher.
Our simulations almost certainly underestimate the contributions of tariffs to growth. They do not include any additional investment surge from foreign or American companies building American factories. There’s no wave of reshoring in our model or expanded export opportunities won through trade negotiations. The gains emerge from the model’s existing economic relationships.
Allow the Fed’s model to recognize the investment incentives arising from higher domestic selling prices, and the projected damage largely disappears. Add a tiny foreign contribution, and both investment and output are higher.
In short, the Fed’s main economic model shows that tariffs raise American output and investment. Isn’t it weird how they never told us about that?
