Intergenerational Welfare Effects of a Tariff under Monopolistic Competition

A dynamic overlapping-generations model of a semi-small open economy with monopolistic competition in the goods market is constructed. A tariff increase reduces real output and employment and improves the terms of trade, both in the impact period and in the new steady state. The tariff shock has significant intergenerational distribution effects which are different for creditor and debtor nations. Bond policy neutralizes the intergenerational inequities and allows the computation of first-best and second-best optimal tariff rates. The first-best tariff exploits national market power, but the second- best tariff contains a correction to account for the existence of a potentially suboptimal product subsidy.