Trade fragmentation, inflationary pressures and monetary policy

How does trade fragmentation affect inflationary pressures? What is the response of monetary policy needed to sustain inflation at target? To answer these questions, we develop a two‑sector, small open‑economy model featuring imperfect international risk‑sharing and household heterogeneity that captures both the supply‑side and demand‑side effects of fragmentation. The impact of fragmentation on inflationary pressures, and the appropriate policy response, depend not only on the direct effect of higher import prices on supply but, crucially, on how aggregate demand adjusts in response to lower real incomes and productivity. In turn, this depends on the pace of fragmentation (whether it is gradual or front‑loaded), as well as several other structural factors elucidated by the model analysis. We compare the outcomes resulting from a central bank following Taylor‑type monetary policy rules to a constrained‑efficient allocation.