Global Economic Effects of Trump 2025 Tariffs | PIIE Study

Liberation Day Tariffs: The Global Shock and Five Scenario Framework

On April 2, 2025, the Trump administration’s “Liberation Day” tariff announcement sent shockwaves through global financial markets. The PIIE Working Paper 25-13 by McKibbin, Noland, and Shuetrim provides the most comprehensive analysis to date of the global economic consequences, modeling five distinct scenarios that capture the spectrum of possible outcomes from minimal disruption to severe global recession.

The initial announcements pushed the average US tariff rate from approximately 3% to roughly 30% — a tenfold increase that represented the most dramatic trade policy shift since the Smoot-Hawley Act of 1930. However, subsequent exemptions, USMCA carveouts, and partial rollbacks created enormous uncertainty about the actual effective tariff levels, making scenario analysis essential for understanding the range of possible outcomes.

What makes this PIIE study uniquely valuable is its inclusion of financial market channels alongside traditional trade effects. The observed April-May 2025 market reaction — a 5% dollar depreciation rather than the appreciation that standard trade models would predict — reveals that investors were pricing something beyond tariffs: they were pricing increased US country risk. The fifth scenario in the PIIE framework explicitly captures this dynamic, providing insights that traditional trade policy analysis typically misses.

PIIE G-Cubed Model: Methodology for Modeling Global Tariff Effects

The analysis employs the G-Cubed model, a hybrid DSGE-CGE framework developed for analyzing global policy shocks. The model covers the US, China, Canada, Mexico, major EU members, advanced and emerging economies, and regional aggregates — capturing the intricate web of trade relationships that transmit tariff shocks globally.

Each economy contains six production sectors — energy, mining, agriculture, durable manufacturing, nondurable manufacturing, and services — with capital, labor, energy, and materials as inputs. Critically, the model captures intermediate input linkages both within and across countries, which is essential for understanding how tariffs on imported components cascade through global supply chains to affect final goods prices and production decisions.

The household sector includes both optimizing consumers (who smooth consumption over time based on forward-looking expectations) and liquidity-constrained consumers (who spend current income). This heterogeneity matters because tariff-driven price increases and employment effects hit liquidity-constrained households immediately, while optimizing households partially buffer through savings adjustments. The World Bank and similar institutions have emphasized that this distributional dimension is often overlooked in aggregate trade analysis.

The baseline forecast projects economic variables from 2025 through 2035 in the absence of any tariff changes. Tariff shocks are then applied as deviations from this baseline, with the timing and magnitude reflecting actual policy announcements and subsequent modifications through mid-2025. The Federal Reserve is modeled as responding to both inflation and output gaps, creating important monetary-fiscal interactions that shape the economy’s adjustment path.

Tariff Scenario Design: High vs Low Disruption Pathways

The five scenarios span a wide range of outcomes, from manageable disruption to severe global recession. Understanding each scenario’s assumptions is essential for interpreting the results.

Scenario 1 (High tariffs, no retaliation) returns to the April 2 announcement levels with explicitly granted exemptions. Key components include 25 percentage point increases on steel, aluminum, and autos; 25 pp on USMCA noncompliant trade; and a massive 45 pp blanket tariff on China plus a 20 pp fentanyl surcharge, pushing some China-specific rates above 65%. This scenario assumes no retaliatory response from trading partners.

Scenario 2 (Low tariffs, no retaliation) assumes the most aggressive tariffs are rolled back to a more modest 10 pp universal tariff outside USMCA, with permanent sectoral carveouts and a reduced 12 pp USMCA noncompliant rate. China still faces elevated rates (30 pp plus the fentanyl surcharge) but substantially below the high scenario. This represents a negotiated de-escalation pathway.

Scenarios 3 and 4 add symmetric retaliation to the high and low tariff cases respectively. The EU retaliates with 20 pp on US exports; China imposes retaliatory tariffs up to 65 pp on certain sectors. Retaliation fundamentally changes the dynamics because it not only raises costs for US exporters but also depresses global trade volumes, reducing the tariff tax base itself.

Scenario 5 (High tariffs + retaliation + country risk) is the most realistic and severe. It adds a 75 basis point increase in the US country risk premium (also applied to Canada and Mexico), calibrated to produce the approximately 5% dollar depreciation observed between April 2 and May 10, 2025. This scenario captures the financial market dimension that purely trade-focused models miss entirely.

US GDP and Macroeconomic Impact Across All Five Scenarios

The range of US GDP outcomes across the five scenarios is striking. In 2026, real GDP losses relative to baseline range from a barely perceptible 0.03% (low tariffs, no retaliation) to a substantial 2.1% (high tariffs with retaliation and increased country risk). Applied to a $30+ trillion economy, the most severe scenario represents over $600 billion in foregone output.

Inflation responses are similarly varied but uniformly positive — all scenarios raise consumer prices. US CPI inflation increases by approximately 0.4 percentage points in the low-tariff scenario (2025) and up to 1.8 percentage points in the most severe scenario combining high tariffs, retaliation, and country risk. Sector-level price effects are more dramatic: durable manufacturing prices jump approximately 6% even in the low-tariff scenario without retaliation, reflecting the concentration of tariff impacts on manufactured goods with imported components.

The GDP losses are persistent rather than temporary. Tariffs permanently reduce the level of potential output by creating efficiency wedges — higher costs for imported inputs, distorted investment incentives, and reduced specialization gains from trade. Unlike a cyclical recession where output eventually returns to potential, the tariff-induced output loss represents a permanent downward shift in the economy’s productive capacity.

Import reductions are substantial across all scenarios. In the low-tariff, no-retaliation case, total US imports decline by approximately 2% of baseline GDP over the projection period. In the most severe scenario, imports fall by roughly 7% of GDP in 2026 — a massive contraction in trade flows that reverberates through global supply chains and affects every major US trading partner.

Global Trade Diversion: Winners and Losers by Country

Perhaps the most policy-relevant finding concerns trade diversion — the redirection of trade flows as tariffs alter relative prices across countries. When the US imposes heavy tariffs on Chinese goods, Chinese exporters do not simply accept lower sales volumes; they redirect production toward alternative markets, creating both winners and losers across the global economy.

The data on durable manufacturing imports from China tells a compelling story. In the high-tariff scenario, developing Asia sees Chinese durable manufacturing imports increase by 1.28% of their GDP — a massive influx of competitively priced manufactured goods. Mexico gains 0.81% of GDP in diverted Chinese durables, Turkey receives 0.71%, Germany absorbs 0.52%, and Canada gains 0.50%. Conversely, US durable manufacturing imports from China decline by 1.83% of US GDP, representing the displacement that drives this global redistribution.

The trade diversion pattern varies significantly by sector. Durable and nondurable manufacturing show the largest redirections, reflecting China’s dominant position in global manufacturing supply chains. Agricultural trade diversion follows different patterns, as China’s retaliatory tariffs on US agricultural exports redirect demand toward South American and Australian suppliers — a dynamic that affected US soybean farmers during the 2018-2019 trade dispute.

For some beneficiary countries, the gains are material enough to partially offset other tariff-related costs. Mexico, despite facing USMCA uncertainty, benefits from displacement of Chinese goods to North American markets. Developing Asian economies receive increased Chinese manufacturing investment and exports that boost their GDP growth in the near term. However, these gains are not without costs — increased dependence on Chinese exports carries strategic risks, and the flood of cheap manufactured goods can disrupt domestic producers in recipient countries.

Exchange Rate Dynamics and the US Country Risk Premium

The exchange rate results reveal a fundamental disconnect between standard trade theory and observed market behavior that is central to understanding the full economic impact of Trump’s tariffs. Standard theory predicts that tariffs should appreciate the importing country’s currency, and the G-Cubed model confirms this: in the low-tariff scenario, the dollar appreciates approximately 3%, and in the high-tariff scenario, it appreciates approximately 8%.

But financial markets told a different story. Between April 2 and May 10, 2025, the US dollar depreciated by approximately 5% against major currencies — the opposite of what tariff-only models predict. The PIIE researchers model this through a 75 basis point increase in the US country risk premium, also applied to Canada and Mexico to capture North American risk contagion.

The country risk channel fundamentally transforms the economic dynamics. Dollar depreciation raises import prices further (amplifying inflation), makes US assets less attractive to foreign investors (triggering capital outflows), and redirects global investment toward economies perceived as safer. Countries that receive these capital inflows benefit from lower domestic interest rates and increased investment, partially offsetting their tariff-related trade losses.

The real 10-year US bond yield responds differently across scenarios. In the low-tariff case, real yields fall by approximately 40 basis points in 2025 as the Federal Reserve eases policy and returns on capital decline. In the risk-shock scenario, US yields rise as investors demand a higher premium for holding US assets, creating tighter financial conditions that further constrain economic recovery. This divergence in yield dynamics has profound implications for government borrowing costs, corporate investment, and housing markets.

Sectoral Impact: Agriculture, Manufacturing and Price Effects

The sectoral decomposition reveals that tariff impacts are far from uniform across the economy. Agriculture and durable manufacturing bear disproportionate costs, while services face more moderate indirect effects through reduced demand and tighter financial conditions.

US agriculture faces a particularly cruel paradox. In the retaliation scenarios, agricultural exports become targets for retaliatory tariffs from China, the EU, and other trading partners. Output prices for agricultural products rise approximately 1% domestically in the low-tariff scenario, but export volumes contract sharply as foreign markets become inaccessible. The combination of higher domestic prices (from tariffs on imported agricultural inputs like fertilizers and equipment) and reduced export revenue creates a severe margin squeeze for American farmers.

Durable manufacturing absorbs the largest price impact, with domestic composite prices rising approximately 6% even in the low-tariff scenario without retaliation. This reflects the sector’s deep integration into global supply chains — tariffs on imported components, subassemblies, and raw materials cascade through production processes, raising costs at every stage. Companies face difficult choices between absorbing margin compression, passing costs to consumers, or restructuring supply chains at significant transition costs.

The energy and mining sectors face complex cross-currents. Tariffs on imported energy inputs raise costs for domestic producers, while retaliatory tariffs from trading partners can reduce export demand. The net sectoral effect depends on the specific tariff rates, exemptions, and the strength of the dollar response — factors that vary significantly across the five scenarios.

Services, while not directly tariffed, suffer through multiple indirect channels. Reduced business investment depresses demand for professional, financial, and technology services. Tighter monetary policy in response to tariff-driven inflation raises borrowing costs that constrain real estate and consumer services. And lower consumer purchasing power — as tariff-inflated goods prices absorb a larger share of household budgets — reduces spending on discretionary services including digital and entertainment services.

Retaliation Amplifies Global Damage and Shifts Capital Flows

The comparison between retaliation and no-retaliation scenarios quantifies a fundamental insight: tariff wars are not zero-sum games — they are negative-sum games where all participants suffer, but the amplification effects are asymmetric across countries and sectors.

Retaliation approximately doubles the US GDP loss in the high-tariff case, from roughly 0.6% to approximately 1.2%. For the global economy, the amplification is even larger because retaliatory tariffs add a second layer of trade barriers affecting different goods and different trading relationships. The EU’s retaliatory tariffs on US goods hit American exporters that are distinct from the sectors affected by US import tariffs, broadening the economic damage across the economy.

Capital flow dynamics shift dramatically with retaliation, particularly in Scenario 5 where the country risk premium rises. Capital outflows from the US benefit economies perceived as relatively safe — a dynamic that can boost GDP growth in receiving countries even as global trade contracts. European, Asian, and other developed economies see lower domestic interest rates and increased investment as global capital seeks alternatives to dollar-denominated assets.

Germany emerges as the most adversely affected large advanced economy in the study, reflecting its extreme trade openness and manufacturing export dependence. However, Germany’s losses are partially offset by capital inflows if the US risk premium rises, creating a complex net effect that depends critically on which scenario materializes. The European Central Bank’s policy response and the EU’s own retaliatory tariff design further shape the European outcome.

Policy Implications for Governments and Global Trade Strategy

The PIIE study delivers several urgent policy implications for governments, central banks, and international institutions navigating the post-Liberation Day trade landscape.

First, exemptions and carveouts are not just diplomatic gestures — they have enormous economic significance. The gap between the high and low tariff scenarios demonstrates that targeted exemptions for USMCA-compliant trade, specific sectors, and strategic products materially reduce economic damage. Governments should prioritize securing exemptions through bilateral and multilateral negotiations.

Second, retaliation imposes costs on both sides, but the amplification effects argue strongly for de-escalation. The economic damage from retaliatory spirals exceeds the sum of individual tariff effects because of cross-border supply chain disruptions, confidence effects, and financial market contagion. The World Trade Organization and other multilateral institutions have critical roles in facilitating face-saving de-escalation mechanisms.

Third, the financial market channel — captured by the country risk premium — can dominate traditional trade effects. The observed dollar depreciation in April-May 2025 was inconsistent with tariff-only dynamics, suggesting that investors were pricing governance risk and policy unpredictability alongside trade disruption. Governments must recognize that trade policy uncertainty has financial stability implications that extend far beyond import-export arithmetic.

Fourth, trade diversion creates both opportunities and risks for third countries. Developing Asian economies and Mexico may benefit from redirected Chinese exports and manufacturing investment, but increased dependence on diverted trade flows creates vulnerability to subsequent policy shifts. Strategic diversification and investment in domestic productive capacity provide more durable economic foundations than reliance on trade diversion windfalls.

Finally, tariffs demonstrably fail to deliver industrial revival. The PIIE model shows that agriculture and durable manufacturing — the sectors tariffs aim to protect — contract in output and employment across all scenarios. The protectionist premise that tariffs will revive domestic industry is contradicted by comprehensive general equilibrium analysis, reinforcing the argument for alternative industrial policy approaches that invest in competitiveness, innovation, and workforce development rather than trade barriers.