Sanctions and the Exchange Rate
What this paper finds — and why it matters
Layer 1 — Core Argument
Itskhoki and Mukhin develop a tractable open-economy model with financial market segmentation — in which only the government sector (including state banks and exporting firms) can intermediate cross-border capital flows — to study how trade and financial sanctions affect the nominal exchange rate. Their first main result is a Lerner-symmetry equivalence: sanctions limiting a country’s exports or freezing its foreign assets depreciate the exchange rate, while sanctions limiting imports appreciate it, even though both types of policies have exactly the same effect on real allocations, including household welfare and government fiscal revenues. The mechanism is direct — export sanctions reduce the supply of foreign currency, requiring depreciation to restore market clearing, whereas import sanctions reduce the demand for foreign currency, requiring appreciation — and because real income effects are identical, the exchange rate movement is not informative about effectiveness: one cannot evaluate the effectiveness of sanctions based solely on the dynamics of the exchange rate. Beyond direct trade sanctions, increased precautionary savings in foreign currency also depreciate the exchange rate when they are not offset by the sale of official reserves or financial repression of foreign-currency savings. Applying the calibrated model to Russia’s post-invasion experience, the dynamics of the ruble exchange rate following Russia’s invasion of Ukraine in February 2022 are quantitatively consistent with the combined effects of these forces calibrated to the observed sanctions and government policies; the combined effect from 2.5 years of sanctions corresponds to a permanent decline in consumption of 0.9% in Russia, while the net effect is close to zero for the rest of the world, and the freeze of FX reserves together with import tariffs act as a positive transfer from Russia to the rest of the world while quantity restrictions on exports raise world energy prices and generate global welfare losses.
Layer 2 — Q&A
Q: What is the core theoretical result on trade sanctions and the exchange rate? A: Proposition 1 establishes that permanent sanctions on imports (raising import prices P*_t by τ) are equivalent in their effect on import consumption and welfare to a combination of permanent sanctions on exports (reducing export prices Q*_t by τ) and a partial seizure of foreign assets (reducing F*_0 by τ). Both sets of sanctions produce the same path of reduced import quantities and the same welfare loss. However, sanctions on exports cum foreign-asset seizure are associated with an additional depreciation of the exchange rate by τ percent relative to import sanctions. This equivalence is a manifestation of Lerner (1936) symmetry extended to a dynamic international macro environment.
Q: What is the intuition for the opposite exchange rate movements under import versus export sanctions? A: Both kinds of sanctions shrink the country’s feasible import consumption set equivalently in real terms, but they operate through different channels. Export sanctions directly reduce the inflow of foreign currency (export revenues fall), so the exchange rate must depreciate to discourage import demand and bring it in line with the reduced budget. Import sanctions raise the price of foreign goods directly; without an offsetting movement, this would create excess demand for domestic non-tradables. To eliminate the excess demand and leave export revenues partially used, the exchange rate must appreciate. In both cases, the import demand schedule — CF_t = (E_t P*_t / P_t)^{-θ} γ Y_t — pins down the exchange rate that supports the same equilibrium import allocation.
Q: Does fiscal equivalence also hold, even when the government relies primarily on exports for revenue? A: Yes. Proposition 1 and the surrounding analysis show that the equivalence result for export and import sanctions extends to the fiscal balance, even when the government relies exclusively on exports for fiscal revenues. The mechanism is a general equilibrium adjustment in the exchange rate: depreciation (under export sanctions) partially ameliorates the impact by increasing the local-currency purchasing power of export revenues, while appreciation (under import sanctions) has the opposite effect. The net fiscal-balance effect of both kinds of sanctions ends up being the same.
Q: What role does the financial market segmentation assumption play? A: The paper assumes a form of financial market segmentation in which only the government sector (including state banks and exporting companies) can intermediate capital flows across the border, subject to international restrictions. This captures both the withdrawal of foreign investors from the Russian market and the segmentation of Russian households from the international financial market due to external sanctions and domestic capital controls. Under this structure, exports and FX reserves are the key sources of currency supply to the economy, and imports plus domestic foreign-currency savings are the key sources of currency demand; the equilibrium exchange rate is determined by the balance of these in the domestic market. Ricardian equivalence for foreign-currency savings does not hold when κ > 0 in the household utility function, so government reserve policy has real effects.
Q: What is the role of precautionary savings demand for foreign currency? A: Households have foreign-currency bonds in their utility function reflecting a precautionary (hedging) demand for future purchases of foreign tradables, parameterized by a shock Ψ_t. When financial conditions collapse — the local stock market crashes, domestic deposits face inflation and bank-run risk, and access to foreign assets is constrained — Ψ_t rises above the real value of household FX savings, creating pressure to accumulate foreign-currency savings despite low expected returns. With inelastic inflow of foreign currency from exports (due to financial sanctions) and no feasible FX reserve sale, a large jump-depreciation is required to restore equilibrium by curbing the increased demand for foreign currency via lower expected returns and higher import prices. The effect is transitory: it dies out as households accumulate enough FX savings. The optimal government response is to sell FX reserves to accommodate household demand without an exchange rate devaluation.
Q: What happens when FX interventions are infeasible? A: When the central bank’s reserves are frozen by sanctions or otherwise unavailable, the government can use financial repression to offset the exchange rate effects of financial shocks. Specifically, by imposing fees on purchasing and withdrawing foreign currency — thereby reducing the household return on foreign-currency deposits R*_H below the international rate R*_t — the central bank can suppress foreign-currency demand. While financial repression is suboptimal in a representative-agent economy, it may be second-best in heterogeneous-agent economies or economies with balance-sheet effects. Importantly, the exchange rate remains allocative even under financial sanctions and financial repression; it is not rendered irrelevant by these policies.
Q: How do the results change when Russia is modeled as a large economy in the commodity market? A: Section 3 extends the analysis to an economy that is large in the world commodity market, modeling Russia as a large commodity exporter, and spelling out specific policy instruments. The paper shows that import prices and export revenues still constitute a sufficient statistic for the macroeconomic effects on the economy under sanctions. However, the welfare implications for the rest of the world depend crucially on whether sanctions take the form of trade taxes or quantity restrictions. A price cap on exported commodities can replicate a tax on exports, achieving the desired wealth transfer to the coalition. In contrast, imposing quantity restrictions on a large commodity exporter reduces global supply and drives up world energy prices, hurting the sanctioned economy when it lowers export revenues, but also imposing substantial costs on senders.
Q: How does the paper calibrate the model to Russia’s ruble dynamics, and how well does it fit? A: The paper employs two calibration strategies. The first reproduces the ex-ante calibration from the 2022 working paper version based on scant data available in the first months after the invasion, without targeting any exchange rate moments. This calibration provides a remarkable out-of-sample fit, predicting accurately the dynamics of the ruble in the following two years. The second is an ex-post calibration that infers structural shocks to perfectly match observed dynamics of Russian imports, exports, commodity prices, domestic output, official FX reserves, inflation, and the exchange rate. Both approaches agree on the decomposition of exchange rate dynamics and confirm the quantitative importance of the theoretical mechanisms.
Q: What does the calibrated decomposition say about the phases of ruble dynamics? A: The initial sharp depreciation in the first weeks after the invasion is mostly driven by increased precautionary demand for foreign currency. The frozen FX assets translate into modest losses of permanent income (only about 3% depreciation), but the asset freeze and sanctions on the Central Bank had a much larger indirect effect by limiting the capacity to accommodate the financial shock with FX interventions. One month out, trade shocks begin to dominate: import restrictions curb FX demand, while the spike in energy prices elevated Russian export revenues, increasing foreign-currency inflows. These forces combined neutralize capital outflows and the surge in financial FX demand, explaining the sharp appreciation of the ruble by summer 2022 (about 30% stronger than pre-war by June). Over time, import quantities recovered as parallel imports and new trade linkages were established, and export revenue inflows contracted as commodity prices declined, bringing the exchange rate back to and then about 20% weaker than pre-war levels.
Q: What are the welfare and fiscal consequences quantified by the calibrated model? A: The initial exchange rate depreciation boosted fiscal revenues by 12%, amplified further by greater export revenues starting in the second month. These effects were offset in the medium run by the exchange rate appreciation due to trade sanctions, with net real income turning negative starting from April 2022. International sanctions decrease long-run real government revenues by about 4%, mostly due to a reduction in export revenues. The combined effect from 2.5 years of sanctions corresponds to a permanent decline in consumption of 0.9% in Russia — vastly larger than conventional estimates of the cost of a business cycle — and close to zero on net for the rest of the world. Consistent with the theoretical results, the freeze of FX reserves and import tariffs act as a positive transfer from Russia to the rest of the world, while quantity restrictions on exports result in higher energy prices, lower consumption, and global welfare losses.
Q: Why cannot the exchange rate be used to evaluate the effectiveness of sanctions in real time? A: Because import sanctions and export sanctions generate opposite exchange rate movements while having exactly the same effect on real allocations, welfare, and fiscal balance, there is no one-to-one mapping between the exchange rate and welfare under sanctions. A strong exchange rate (appreciation) after sanctions may reflect import restrictions — which are just as effective in reducing real income as export restrictions that would have caused depreciation. Conversely, a weak exchange rate need not imply sanctions are ineffective; it may simply reflect that sanctions took the form of export or asset-freeze measures. The ruble’s rapid appreciation through summer 2022 illustrates this: rather than indicating that sanctions failed, it was largely consistent with the combination of import restrictions and high commodity prices, while the underlying real income effect was substantially negative.
Key Concepts
Lerner symmetry (macroeconomic version): The principle, originating in Lerner (1936), that a uniform import tariff and a uniform export tax yield the same real economic outcomes — the same allocation and welfare — but are sustained by a differential movement in relative prices (appreciation versus depreciation). In the paper’s context, both import and export sanctions of equivalent magnitude reduce the real income of the sanctioned economy by the same amount and produce the same path of import consumption and welfare, even though they move the exchange rate in opposite directions.
Financial market segmentation: The model’s departure from standard international macro in which only the government sector (including state banks and exporting companies) can intermediate cross-border capital flows, subject to international restrictions. Households cannot freely access international financial markets. This makes exports and FX reserves the only sources of foreign-currency supply to the domestic economy, and imports plus domestic foreign-currency savings the only sources of demand, so the exchange rate is determined entirely by the domestic balance of these flows.
Precautionary foreign-currency demand shock (Ψ_t): A shock that raises the household bliss-point for real foreign-currency bond holdings above the current stock, capturing a collapse in the supply of alternative savings vehicles (domestic stocks, bank deposits, access to foreign assets). In the model it enters households’ utility directly; an increase in Ψ_t above real FX savings creates depreciatory pressure on the exchange rate when not offset by FX reserve sales or financial repression.
Financial repression (in the model): Government suppression of the household rate of return on foreign-currency deposits R*_H below the international rate R*_t, implemented via fees on purchasing and withdrawing foreign currency. It offsets the depreciatory effect of a precautionary savings shock without requiring FX reserve sales, at the cost of a distortion in the domestic financial market. The paper notes Russia introduced such fees in March–April 2022.
Sufficient statistic for macroeconomic effects: When the sanctioned economy is large (as Russia is in global energy markets), import prices and export revenues still constitute a sufficient statistic for the macroeconomic effects of sanctions on the economy — i.e., the same pair of variables summarizes welfare, fiscal, and exchange rate outcomes regardless of the specific instrument used to impose sanctions, provided the terms of trade deterioration is the same.
Price cap (as an export tax equivalent): A price cap on a sanctioned country’s exported commodities can replicate the effect of a tax on exports from the coalition’s perspective, achieving the same real-income transfer from the sanctioned country to the rest of the world without reducing global supply (as quantity restrictions do). This distinguishes it from quantity restrictions on exports, which reduce global energy supply and impose welfare costs on the coalition.
Summary based on LSE Research Online accepted version. AI-assisted, human review pending.