If an import tariff causes currency appreciation, how is PPP restored?

External question — Economics Stack Exchange Author: Bob Zorro Original post: https://economics.stackexchange.com/questions/60260 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. John Cochrane ( https://johnhcochrane.blogspot.com/2018/07/trade-war.html ) and others have argued that import tariffs can't eliminate trade deficits. This is because Net Exports = Saving - Investment, and we're assuming the tariff doesn't affect saving or investment. If the US imposes a 100% tariff on imports, there will be fewer imports which will reduce the supply of dollars, causing the dollar to appreciate, lowering exports so that the trade balance is unchanged. Under fixed exchange rates, price levels adjust so that the real exchange rate rises, so the end result is the same: the trade balance is unchanged. I am wondering, though, how would purchasing power parity be restored?

External answer — Economics Stack Exchange Author: ahorn Original post: https://economics.stackexchange.com/a/60276 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. Trade imbalances disrupt purchasing power parity because persistent trade surpluses strengthen a currency, while persistent trade deficits weaken a currency, without necessarily driving prices towards parity. Foreign currency exchange linked to these trade activities determine the exchange rate. Arbitrage (in the form of exporting or importing goods and services in the reverse direction) is held back by market demand.

External answer — Economics Stack Exchange Author: Bob Zorro Original post: https://economics.stackexchange.com/a/60302 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. A tariff drives a wedge between the prices of the same good in two countries, raising the import price relative to the export price, and preventing arbitrage from restoring PPP. To quote Sarno and Taylor (2002) , the presence of any sort of tariffs, transport costs, and other nontariff barriers and duties would induce a violation of the no-arbitrage condition and, inevitably, of the LOP [Law of One Price].