Two-Country HANK and trade friction

Abstract

Compared to the Two-Country Representative Agents and the Small Open Economy Heterogeneous Agents models, this paper develops a Two-Country Heterogeneous Agents New Keynesian model, building a heterogeneous and endogenous channel of mutual investments on foreign illiquid assets and exploring two countries’ wealth distribution and inequality. This model explores the impacts of trade barriers on the two countries’ economic structures and behaviors. In the symmetric economy, the first launcher of tariffs suffers higher losses from the trade war, the other that does not launch tariffs suffers fewer losses. The two countries both suffer higher losses if the two sides simultaneously launch the trade war. However, in the asymmetrical economy, the country with a larger economic scale and higher productivities suffers lower losses from the trade war. Thus the high-tech country has the motivation to launch the trade war at a lower cost than the low-tech country. This paper implies that the trade war only occurs in asymmetric economies. The low-tech country can change its dilemma by improving technology because higher technology can enhance the quality level of products, stimulate economic consumption and investments, and finally offset the loss from tariff friction. Meanwhile, the trade detour is also an effective means to reduce the loss resulted from trade friction.