The United States under President Donald Trump launched a tariff war with China, imposing steep tariffs on hundreds of billions of dollars of Chinese imports. China retaliated in kind, escalating a tit-for-tat trade conflict that disrupted global supply chains and rattled financial markets. This period saw surging uncertainty: safe-haven assets like gold spiked to record highs, U.S. bond yields surged, and the dollar slumped in value, reflecting a flight from U.S. assets amid waning investor confidence. Inflation fears in the U.S. climbed and recession risks rose.
This paper applies the Mundell-Fleming model (IS–LM–BoP framework) for a floating exchange rate regime to analyze these events. The focus uses the model’s insights on exchange rates, capital flows, and policy effectiveness under perfect capital mobility – to evaluate U.S. macroeconomic dynamics during the tariff war. Then analysis extends to implications for Indonesia as a small open economy.
Analysis: The U.S. Tariff War through the Mundell-Fleming Lens
Using the Mundell-Fleming IS-LM-BoP framework, we can interpret the U.S. macroeconomic developments during Trump’s tariff war as a combination of shocks to the IS curve (from tariffs and trade changes), to the LM/monetary outlook (via inflation expectations), and to the BoP/capital flows (via changes in investor sentiment).
1. IS Shock: Tariffs directly affect the net export component of aggregate demand.
By imposing tariffs on Chinese (and other countries) imports, the U.S. aimed to reduce imports and improve its trade balance (other things equal, a reduction in imports raises NX). In a static IS-LM analysis, a rise in net exports would shift the IS curve to the right (analogous to an increase in autonomous demand). This by itself is an expansionary impulse: at initial interest rates and exchange rates, output would tend to rise.
However, the tariff war also invited retaliation: China raised tariffs on U.S. goods (in the scenario, up to 125% on certain imports[i] ), which hurts U.S. export volumes. The net effect on U.S. NX is ambiguous – it depends on the balance of reduced imports versus lost exports.
2. Exchange Rate: Under floating exchange rates and high capital mobility, any such IS-driven expansion faces the exchange rate counter-balancing mechanism.
The moment U.S. output and interest rates begin to climb from the IS shift, foreign capital pours in to capture the (expected) higher returns, putting upward pressure on the dollar. The U.S. dollar “would” appreciate, making U.S. exports less competitive and imports cheaper. This appreciation erodes net exports, negating the expansion.
However, what occurred during the tariff war is different in an important way: instead of the dollar strengthening, it weakenedsharply . This implies that capital did not flow into the U.S. seeking higher returns—rather, investors lost confidence in “America” and capital flowed out despite higher U.S. yields .
In the Mundell-Fleming framework, we can interpret this as an increase in the risk premium on U.S. assets or expected depreciation of the dollar, which alters the BoP condition. Essentially, the BoP curve is no longer horizontal at i = i*, but at i = i* + ρ (where ρ is a risk premium). The tariff war, by injecting uncertainty and fears of stagflation, raised ρ.
3. Crowding Out
Consequently, instead of a capital inflow and dollar appreciation crowding out net exports, the U.S. experienced capital flightand dollar depreciation even as fiscal/IS forces were pushing up interest rates.
Note that foreign investors rebalanced their portfolios away from U.S, driving the dollar down in spite of what IS-LM logic alone might predict .
4. Rising Inflation and Monetary Expectations (LM shift)
The imposition of tariffs raised production costs and import prices in the U.S., contributing to a spike in inflation expectations.
In the IS-LM model, if people anticipate higher inflation or the central bank reacts to tariff-induced price pressures, this can effectively tighten monetary conditions. The Federal Reserve in reality was inclined to raise interest rates partly due to possible inflationary pressures.
Then, rising inflation expectations shifts the LM curve to the left (for a given money supply, higher expected prices reduce real balances or prompt the Fed to reduce the nominal money supply growth). A leftward LM shift drives interest rates up and output down. Thus, while fiscal/trade policy was (marginally) pushing IS right, monetary factors were pushing LM left, working against output expansion. The net effect would be higher interest rates in equilibrium.
5. BoP Shock: Capital Flight and Exchange Rate Dynamics
The key factor in this tariff war is perhaps the “flight from U.S. assets” by investors panicky by the trade war and rising inflation/recession fears. In the Mundell-Fleming model, an exodus of foreign capital manifests as a BoP deficit at the initial exchange rate.
With a floating dollar, the adjustment comes through currency depreciation: the excess supply of dollars in the forex market drives the dollar’s value down until investors are willing to stay – either because U.S. assets have become cheaper (and yields higher in currency-adjusted terms) or because the weaker dollar promises future appreciation.
In essence, the exchange rate must fall enough to create an expectation of gain (or a large NX improvement) that matches the heightened risk. This mechanism is consistent with interest parity: a rise in risk premium ρ requires a combination of higher domestic interest and an immediate depreciation so that investors anticipate the currency might rebound (or at least that U.S. assets now yield more after the depreciation) .
In an open economy with mobile capital, confidence and expectations are crucial: a loss of confidence can invert the typical response. During the trade war, the dollar’s decline was the market’s way of equilibrating the BoP in face of capital outflows.
Implications for Indonesia as a Small Open Economy
The U.S.-China trade war and its financial fallout also had significant spillover effects globally. Indonesia, as a small open economy with a floating exchange rate and increasing capital mobility, provides a useful case to examine how such external shocks transmit.
In the Mundell-Fleming, a small open economy takes the world interest rate and foreign income as given – it cannot influence these but is influenced by them. We analyze three major external shock channels – trade disruptions, capital flight, and dollar/rupiah depreciation – on Indonesia:
Trade Disruptions and External Demand
Indonesia would also be hit by the trade channel of the U.S.-China conflict (either directly or indirectly). A slowdown in U.S. growth or Chinese growth due to the tariffs reduces demand for Indonesia’s exports (e.g. commodities). In the IS-LM-BoP model, this is a decline in foreign demand that shifts Indonesia’s IS curve to the left. Lower export revenue means at each interest rate, aggregate demand is weaker. This negative IS shock reduces output and, all else equal, puts downward pressure on Indonesian interest rates.
However, under perfect capital mobility, Indonesia’s interest rate is still largely tied to the global rate (i*). So instead of a fall in i, what would happen is the rupiah might depreciate further to stimulate net exports (a new IS-BP equilibrium with a weaker currency)
Capital Flow Pressures
Indonesia is likely to experience capital outflows as well, as part of a general retreat from risk (also due to its own fundamental factors as well: budget deficit, low tax income, etc). In MF terms, at the initial interest rate Indonesia faces a BoP deficit (capital account outflow) when global investors pull funds.
Two adjustment paths are possible:
- Interest Rate Increase: Bank Indonesia could allow or bring domestic interest rates to rise in line with global rates/risk premia to retain capital. This would correspond to moving up along the LM curve (or shifting LM left if done via monetary tightening).
2. Exchange Rate Depreciation: Alternatively, a more likely scenario, Indonesia can let the rupiah depreciate in response to the capital outflow. A freely floating rupiah will fall until the expected returns equalize. The immediate depreciation helps to re-equilibrate the BoP by making Indonesian assets cheaper and potentially attractive, and by boosting net exports. According to MF theory, capital outflows lead to currency depreciation, which makes exports cheaper and improves the current account.
Dollar Depreciation (USD Value Changes) and IDR Depreciation
A notable outcome of the U.S. turmoil was a depreciation of the U.S. dollar against other major currencies. Unfortunately, for Indonesia, at the same time, the Rupiah also depreciates in the same period. Thus, the overall effect might be small.
Overall, the shocks from the U.S. trade war likely translated into downward pressure on Indonesia’s output (primarily driven by lower NX), upward pressure on domestic interest rates (to the extent they needed to follow global rates), and a volatile rupiah.
Conclusion
In summary, the Mundell-Fleming framework shows that Trump’s tariff war, in a world of free capital mobility, was theoretically destined to be an ineffective growth strategy for the U.S. – fiscal/trade policy gains were offset by market reactions. The only clear impact was a change in the mix of GDP (less imports, more net exports, but no net growth, and higher risk premia).
In addition, policy effectiveness and macroeconomic performance in one country cannot be analyzed in isolation. The tariff war episode thus provides a textbook validation of open-economy macro concepts – exchange rates matter enormously, and when capital is free to move, it will often undermine fiscal actions while amplifying monetary ones, for better or worse .
[i] https://www.euronews.com/business/2025/04/21/china-vows-retaliation-against-countries-supporting-us-led-trade-isolation
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