Tariff Policy, Increasing Returns and Endogenous Fluctuations

We study the effects of government tariff policy in a one-sector small open economy RBC model with a productive externality that generates social increasing returns to scale. Various forms of endogenous fluctuations, including stable 2-, 4-, 8-, and 15-cycles, quasiperiodic orbits and chaos can be identified in this model if we introduce a constant tariff or subsidy (applied to the imported production factor) into the laissez-faire economy that exhibits local indeterminacy. In a somewhat different model, Guo and Lansing (2002) show that a constant capital tax or subsidy can give rise to similar dynamics in a closed-economy one sector model with a productive externality. From this perspective, factor income taxes and tariffs are equivalent to generate endogenous fluctuations in those economies with social increasing returns to scale. We further show that in our model, the local determinacy can coexist with the global indeterminacy for a plausible range of tariff rates, which brings our attention to the use of local steady state analysis to make conclusions about the global dynamics of the nonlinear models.