Asset Markets, Tariffs, and Political Risk

The paper examines a simple model in which exogenous political risk creates uncertainty about tariffs. The model predicts a relation between consumption and tariffs that differs radically from that implied by models without asset markets or political risk. Given the probability distribution of tariffs, domestic consumption and utility (ex post) are lower in states of the world with a domestic tariff and no foreign tariff than with a foreign tariff and no domestic tariff.This conclusion emerges despite the fact that the opposite would be obtained in the absence of asset markets. So economists should not be surprised if observed relations between consumption and tariffs differ from the predictions of static theory in either time-series or cross-sections.