Countries are panicking, reacting impulsively, and focusing more on immediate disruptions than on long-term economic impacts. However, for meaningful discourse, economists, central banks and political leaders need to assess these developments through a macroeconomic lens.
Countries are panicking, reacting impulsively, and focusing more on immediate disruptions than on long-term economic impacts. However, for meaningful discourse, economists, central banks and political leaders need to assess these developments through a macroeconomic lens.
One key framework for understanding and predicting the direction of such policies is the Aggregate Demand (AD) and Aggregate Supply (AS) model, which helps evaluate both short-run fluctuations and long-term consequences. For more precise estimations, Computable General Equilibrium (CGE) models can be employed to explore potential scenarios or assess the impact of recent tariff policies.
Let us consider three possible international responses to US-imposed tariffs: equal retaliation, asymmetric response and aggressive retaliation. In the first case of equal retaliation -- commonly referred to as a tit-for-tat approach -- Country A imposes equivalent tariffs on US exports in response to US tariffs. In this scenario, both countries experience a reduction in export volumes and higher import prices, leading to a decline in net exports.
A natural follow-up question might be: to what extent will both countries experience this decline? The answer depends on several factors, including price elasticity of demand, availability of substitutes, exchange rate movements, and the structure of supply chains. From a macroeconomic perspective, this will result in a leftward shift of the AD curve, reducing real GDP and increasing unemployment in the short run -- particularly if the drop in net exports is not offset by increases in domestic consumption or investment.
This mutual economic blow is likely to generate public and media pressure, pushing both countries toward the negotiating table. Another question that may arise is: how soon could these negotiations take place? The answer depends largely on the political climate in both countries and whether it supports the formation of a fair-trade agreement aimed at securing long-term economic stability -- something more realistic than an idealistic free trade agreement.
However, if geopolitical tensions persist and negotiations either stall or fail, two likely outcomes may follow: trade diversion and a shift toward self-sufficiency campaigns in the long run. To achieve a higher long-run equilibrium, countries must prioritise promoting efficiency and specialisation.
Now, moving on to soft retaliation, often referred to as an asymmetric response. In this scenario, let us assume Country B imposes less severe retaliatory measures, possibly due to diplomatic ties or strategic restraint. As a result, Country B’s exports may decline more sharply, while imports from the US continue with fewer barriers. This situation can lead to a worsening trade balance, lower net exports and a leftward shift in aggregate demand (AD).
The new tariffs may lead to a range of global responses but countries are still hopeful that the US will be encouraged to have more balanced, resilient and fair economic partnerships for global sustainability
These conditions may trigger domestic unrest and prompt demands for reciprocal action or renegotiation from pressure groups and business lobbies. If the government yields to these pressures, Country B may escalate tariffs or pursue new fair-trade agreements. However, if the government remains passive, the continued trade imbalance could lead to currency depreciation, widening inequalities, and slower long-term growth. Aggregate demand would remain low, keeping real GDP below potential GDP and contributing to rising unemployment.
Developing countries like Pakistan should be cautious of adopting such a passive stance, as it could negatively impact export-led initiatives -- such as the URAAN project -- which rely on maintaining favourable trade agreements.
The third condition is aggressive retaliation which is not only limited to tariffs but also to investment restrictions on Foreign direct investment, infrastructure investment, etc. This situation leads to a trade balance for Country C if Country C has already exported more than its imports.
However, reducing investment will have negative consequences for both countries. The US economy may face challenges of lower capital from Country C to the US, but Country C could also face reduced returns on its capital due to ignoring opportunities in the US markets. This case resembles ‘beggar thy neighbour’ policies from trade history, but such policies will have worse long-term situations due to capital inefficiency, supply chain disruptions and loss of investor confidence.
Along with that, Country C needs to redirect capital to other countries, develop a strong national innovation system and promote self-reliance in production and technology. Because, if it fails after this aggressive move, it can face isolation and reduced economic growth.
In all three cases, we can predict that some macroeconomic outcomes are more likely, for instance in the short run AD declines, real GDP falls below potential GDP, rising unemployment and recession episodes. Along with these, there are chances of frequent financial market crashes, and higher volatility, currency depreciation, capital flight and income inequality may affect poor economies.
Despite this huge trade war ahead, how can countries save their economies with minimum losses? Some approaches can secure economies. First, strong political coordination and timely monetary policy responses from central banks that require more independent decisions. Second, attracting investment in technology and domestic production capacity to maintain competitiveness. Third, support for innovation, intellectual property, and Research and development (R&D) that enhances long-run sustainability.
Finally, it is important to acknowledge that the US has long been a global leader in innovation, trade and economic resilience. Such tariffs may lead to a range of global responses but countries are still hopeful that the US will be encouraged to have more balanced, resilient and fair economic partnerships for global sustainability.
The writer is an assistant professor at the School of Economics & Social Sciences (SESS), IBA.
