Oleg Itskhoki on Sanctions and Exchange Rate

On Thursday, June 23, Oleg Itskhoki will join Markus’ Academy for a lecture. Oleg Itskhoki holds the Venu and Ana Kotamraju Endowed Chair in Economics at the University of California, Los Angeles.

Watch the livestream below. You can also watch all Markus’ Academy webinars on the Markus’ Academy YouTube channel.

Timestamps:

[0:00] Introductory remarks
[6:53] Importance of this research
[24:40] The general model
[46:10] Trade sanctions and policies
[56:00] Modeling General Equivalence
[1:05:29] Modeling Financial Shock
1:12:41] Concluding remarks

Executive Summary

• [0:00] Introductory remarks. This is one of several Markus’ Academy webinars on sanctions, the rest of which can be found here. There are several reasons why having the perception of a strong exchange rate is important: inflation pressures are not as strong, the likelihood of a bank run is lower, and this allows for a lower policy rate. Recently, Russia has been exporting oils at a high price, particularly to China; Russia’s total trade surplus has gone up as imports have decreased and the price of oil has increased.
• [6:53] Importance of this research. The war in Ukraine is unprecedented and will have major impacts on the rest of the world. Between 2014 and 2022, the Ruble-USD exchange rate was relatively stable, but at the start of the invasion, the ruble rapidly depreciated, and then a month later, it had a major turnaround and has appreciated significantly. The paper addresses questions about this depreciation, whether sanctions are working, whether the exchange rate is relevant, and what are implications for government revenue. It builds off of an earlier equilibrium exchange rate model, streamlined to focus on exchange rate, the real cost of living, and government revenues. Foreign currency has a dual role, both in the goods market and the asset market; the exchange rate balances the demand (for imports and savings) and supply (from exports and net foreign assets) in the currency market.
• [24:40] The general model. A relatively simple small open economy with tradables, non-tradables, and demand for foreign currency savings. There is one equation for households, which includes domestic good consumptions, imports, constrained by exchange rates, bond prices, and wage yields. There is also one for the government, firms and the financial sectors, which includes net foreign assets, privately held foreign assets, different interest rates, the country’s inflation, endowment, and the household wage commitment. The government can control inflation, financial repression, and reserves; endogenous variables are imports, exchange rates, and foreign currency savings.
• [46:10] Trade sanctions and policies. There can be sanctions on imports or exports, withdrawals of intermediates, freezing foreign assets, and exclusion from international markets. Using a Cobb-Douglass utility function, by combining the budget constraint and the demand for import schedule, equilibrium exchange rate is solved. This equation shows that sanctions that are focused on net foreign assets or exports will depreciate the exchange rate, because it is harder to afford imports. Domestic inflation will depreciate the exchange rate, while domestic recession will appreciate the exchange rate. Import sanctions will cause a ruble appreciation in order for the currency markets to clear.
• [56:00] Modeling General Equivalence. Lerner (1936) showed that an import tariff is equivalent to an export tax, which can be shown in this model. Export sanctions with a partial net foreign assets freeze will have the same result as import sanctions, because they will have the same allocation, welfare, and reduction in imports. However, there will be opposite changes in the exchange rate; export sanctions lead to depreciation, while import sanctions lead to appreciation. This also leads to the same real cost of living shift.
• [1:05:29] Modeling Financial Shock. There are three ways the government can respond: use reserves to support the households (but that can only happen if there are reserves); do nothing; or do financial repression. Typical foreign exchange rate policy through selling reserves would not cause movement in import or exchange rates. Passive government means imports fall and exchange rates depreciate. Financial repression means that the government reduces expected return on foreign currency, taxes foreign currency, or bans exporting currency; all of this was done in the first few weeks of Russia’s invasion of Ukraine.
• [1:12:41] Concluding remarks. Financial repression reduces welfare in a representative agent economy, but with heterogeneous agents, repression hurts the savers but benefits consumers, meaning it can sometimes be helpful. The ruble first depreciated because of a freeze of government reserves and the threat of export sanctions, but then started appreciating because of tougher sanctions on imports than exports (increased supply of foreign currency), as well as capital controls and financial repression. Sanction effectiveness cannot be inferred from exchange rate dynamics alone. The exchange rate affects imports and government revenues, meaning that it is not irrelevant. There are a lot of forces for ruble depreciation going forward, but some of these future shocks may have already been priced in.