Dynamic Effects of Industrial Policies Amidst Geoeconomic Tensions

Amid ongoing geoeconomic tensions, industrial policy has emerged as a prominent tool for policymakers. What are the dynamic and welfare effects of these policies? How does the short-sightedness of policymakers influence their choice of instruments? What are the distributional consequences of these protectionist measures? We address these questions with a dynamic two-country open-economy macro framework that incorporates firm heterogeneity, trade, and the offshoring of tasks. By calibrating the model to the contexts of the US and China, we explore the effects of four popular industrial policies: import tariffs, offshoring friction, domestic production subsidies, and entry subsidies. Our findings indicate that myopic policymakers are incentivized to subsidize production, while more forward-looking policymakers favor imposing import tariffs. Although all of these policies initially reduce wage inequality, some result in aggregate welfare losses, either in the short run or the long run.