Geopolitical risks (GPR) and the sanctions they often trigger can disrupt economies, particularly in targeted nations. Using Russia as a case study, this paper develops a simple economic model to understand how GPR shocks and sanctions affect the targeted country’s output, inflation, and monetary policy. The authors explore how sanctions amplify the economic consequences of geopolitical tensions for Russia and assess the role of monetary policy in mitigating these effects.

Geopolitical events such as conflicts or diplomatic crises can have profound economic consequences. These events often lead to sanctions, which further exacerbate economic disruptions. While previous research has examined the effects of GPR on Western economies, this paper focuses on the economic impact of GPR shocks on a sanctioned country, specifically Russia. The authors aim to answer two key questions: How do GPR shocks and sanctions affect the macroeconomy? And how should monetary policy respond to these shocks? 

To answer these questions, the authors employ a three-equation New Keynesian model tailored to a small open economy and calibrated using Russian data. In this framework, GPR shocks are treated as negative productivity shocks, while sanctions are modeled as import tariffs that act as cost-push shocks. The model incorporates key features such as consumption habits and inflation indexation to capture the persistent effects of shocks. To validate the model, the authors use a vector autoregression analysis of Russian macroeconomic data from 2002 to 2021, excluding post-2022 data due to reliability concerns. The model parameters are estimated by matching the empirical impulse responses of output, inflation, and interest rates to GPR shocks.

Theoretical Framework: Geopolitical Risk and Sanctions as Economic Shocks 

The authors conceptualize GPR shocks as disruptions to productivity, reflecting the misallocation of resources during geopolitical crises. For example, military buildups or economic uncertainty can reduce labor productivity and total factor productivity. Sanctions, on the other hand, are modeled as trade shocks that increase import prices, acting as cost-push shocks in the Phillips Curve. These shocks raise inflation and reduce output, particularly in the short run when trade elasticities are low. The model also incorporates a sanctions policy rule, where sanctions are imposed in response to increases in GPR. This approach allows the authors to analyze the interaction between GPR shocks, sanctions, and monetary policy.

Key Findings: The Amplifying Role of Sanctions 

The model reveals that GPR shocks alone have a modest impact on output and inflation. However, when sanctions are introduced, the economic effects become significantly more pronounced. Key findings include: 

1. Output and inflation dynamics: GPR shocks reduce output and increase inflation, but sanctions amplify these effects, raising import prices and driving inflation higher. In the case of Russia, sanctions were found to be the primary driver of inflationary pressures following GPR shocks.
2. Monetary policy responses: The central bank responds to GPR shocks and sanctions by raising interest rates to contain inflation. However, this tightening exacerbates the decline in output, creating a policy trade-off. The authors find that Russia’s monetary policy is more accommodative than the standard Taylor rule, likely reflecting the need to balance inflation control with output stabilization.
3. Counterfactual analysis: In a scenario without sanctions, the economic impact of GPR shocks is relatively mild, with only a small decline in output and a modest rise in inflation. Conversely, more severe sanctions lead to deeper recessions and higher inflation, underscoring the significant role that sanctions play in shaping economic outcomes. 

Implications for Monetary Policy 

The findings highlight the complex trade-offs faced by central banks in sanctioned economies. Sanctions act as cost-push shocks, shifting the Phillips Curve upward and forcing central banks to choose between stabilizing inflation and supporting output. The authors argue that an optimal monetary policy in this context would tolerate temporarily higher inflation to cushion the decline in economic activity. This approach aligns with recent theoretical work suggesting that strict inflation targeting may not be appropriate in the presence of trade shocks such as sanctions.

Conclusion 

This paper provides a novel framework for understanding the economic effects of geopolitical risk and sanctions. By modeling GPR shocks as productivity disruptions and sanctions as cost-push shocks, the authors capture the key dynamics observed in the Russian economy. The findings emphasize the amplifying role of sanctions in deepening economic contractions and driving inflation. They also highlight the importance of accommodative monetary policy in mitigating these effects. Future research could extend this framework to analyze sector-specific sanctions or the global spillover effects of sanctions on sender countries. 

In sum, this study offers valuable insights for policymakers navigating the economic challenges posed by geopolitical tensions and sanctions. It underscores the need for nuanced monetary policy responses that balance inflation control with economic stability.