Precautionary Protectionism

Abstract

We develop a dynamic extension of Dornbusch et al. (1977) with “rustiness”: the home country has relatively higher unit costs tomorrow for goods it is not producing today. We solve for optimal tariff policy when there is a potential for a crisis: an increase in demand for goods produced abroad. Optimally, the home planner never protects goods where comparative advantage is sufficiently low, not even the goods directly affected by the crises. However, for marginally competitive goods, the optimal policy trades off comparative advantage and demand. The extent of industrial policy is non-monotonic in both the size of the demand shock and in its variance.