Sanctions Induced Terms of Trade Shocks and the Role of Lean Against the Wind Policy

Economic sanctions have recently become a prominent tool in international policymaking. However, the mechanisms through which sanctions are transmitted and their impact on the domestic financial sector remain unclear. This paper employs a calibrated New Keynesian small open economy model to analyze the transmission channels of sanctions-induced terms of trade shocks and their impact on the economy. The rise in the domestic prices of imports is a crucial channel through which trade restrictions affect the economy due to the production sector’s reliance on imported investment goods. The findings indicate that both export and import sanctions lead to similar outcomes: a fall in investment caused by a 10% reduction in the price of exported goods or a 10% increase in the price of imported goods results in over a 2% contraction in domestic production, accompanied by a rise in non-performing loan rates among firms and households. Countercyclical lean against the wind (LAW) monetary policy facilitates a quicker recovery in production by encouraging the substitution of imported investment goods with domestically produced alternatives and improves financial stability in the consumer debt market.