International Trade and Macroeconomic Dynamics with Sanctions

This research develops an analytical framework to understand the short-, medium-, and long-term consequences of economic sanctions on international trade and macroeconomic activity. The results provide a roadmap on how several types of sanctions, trade and financial, might work, how they might affect individual agents, trade, and macroeconomic aggregates in the targeted country and the global economy when that country is not small. The results also show that the exchange rate is not a useful metric for evaluating the effectiveness of sanctions. The targeted country's currency depreciation or appreciation reflects the type of sanction and how economies adjust by reallocating resources across production sectors. The framework provides guidance for policy by determining the optimal menu of sanctions that a government would want to impose, how this menu is affected by international coordination or lack thereof, and the implications of sanctions for the conduct of fiscal and monetary policies. This research is relevant for the discussions of the economic effects of ongoing geopolitical tensions and for an understanding of economic warfare.

The analysis begins with a tractable mathematical model of two countries, Home and Foreign, with comparative advantage in production of differentiated consumption goods (Home) or a homogeneous commodity (e.g., gas—Foreign). Home imposes trade and financial sanctions on Foreign. Trade sanctions are introduced through (i) a ban on international gas trade or (ii) the exclusion of most productive consumption-sector firms from international trade. Financial sanctions imply the exclusion of a portion of Foreign agents from international asset markets (when all Foreign agents are excluded, financial sanctions imply financial autarky). Changes in the range of products available to consumers are central to the transmissions of sanctions. For instance, in response to sanctions that prohibit the most productive Home firms from exporting to Foreign, average Home exporter productivity falls, and the average price of Foreign imports rises. Foreign households shift demand toward domestic goods produced by Foreign firms that are less productive than Home exporters. A higher average import price and the shift in demand toward domestic goods cause the Foreign price level to rise and the Home exchange rate to depreciate. In response to a ban on gas trade, Foreign adjusts by shifting resources to production of consumption goods to replace lost export revenue. The number of Foreign consumption exporters rises, and their average productivity falls, resulting in a higher average price of Home imports and Home exchange rate appreciation. When a third country is added to the framework, the impact of substitution effects on trade and international sanctions coordination can be investigated. The results of these exercises, in which sanctions are taken as exogenously given, provide the foundation for the next part of the research agenda, which focuses on the optimal choice of sanctions, their interaction with fiscal and monetary policies, and how macroeconomic policymakers should respond to the effects of sanctions.