A simple model of geopolitical risk and sanctions

Geopolitical risk (GPR) shocks that trigger the imposition of sanctions tend to lower output and raise inflation in the sanctioned country. We develop a three-equation small open economy New Keynesian model where GPR shocks are modeled as negative productivity shocks and sanctions manifest as import tariffs in response to GPR increases. We calibrate the GPR process, sanction rule, and interest rate rule to match the observed dynamics of the GPR index, output, inflation, and the policy rate in Russian data. The sanction response to GPR allows the resulting model to capture the empirical impulse responses well. Additionally, we find that Russia's monetary policy rule is more accommodative than prescribed by the standard Taylor rule. While this may reflect policy preferences, recent theoretical results indicate that such a policy stance may be optimal when sanctions act as cost-push shocks that shift the Phillips Curve.