POLICY BRIEF

22-5 Fiscal support and monetary vigilance:

Economic policy implications of the Russia-
Ukraine war for the European Union
Olivier J. Blanchard and Jean Pisani-Ferry
April 2022

Authors’ Note: This Policy Brief builds on a March 10 PIIE blog post by Jean Pisani-
Ferry, ”Europe’s economic response to the Russia-Ukraine war will redefine its priorities
and future.” We are grateful to Thomas Belaich for research assistance and to Agnès
Bénassy-Quéré, Steven Fries, Philip Lane, Elina Ribakova, Guntram Wolff, and PIIE
colleagues for their comments on an earlier draft. Throughout this Policy Brief, we take
mid-April as the cutoff date for data.

INTRODUCTION
Nobody can predict with much confidence how the war in Ukraine will evolve and Olivier J. Blanchard is the
C. Fred Bergsten Senior
what its geopolitical consequences will be over the next few months, let alone the Fellow at the Peterson
next few years. Nevertheless, policymakers must think about the implications of Institute for International
the war and the appropriate responses, realizing that they will need to be adapted Economics.

as circumstances evolve. Moreover, they must think coherently about the joint Jean Pisani-Ferry is
nonresident senior fellow
implications of their actions, from sanctions on Russia to subsidies and transfers at the Peterson Institute for
to their own citizens, and avoid taking measures that contradict each other. This is International Economics.
He is also senior fellow
what we try to do in this Policy Brief, focusing on the macroeconomic aspects of
at Bruegel and Tommaso
relevance for Europe. Padoa-Schioppa Chair at
We start by exploring the potential implications of the war. We review the the European University
Institute.
various channels through which it is affecting macroeconomic perspectives. The
upshot is that although demand, financial, and wealth channels all enter into
play, and although the direct budgetary implications of the war matter—because
of increased defense spending and the cost of protecting refugees—the war’s
main impact on Europe is likely to be felt through energy prices and, to a lesser
extent, food prices.
We then discuss the factors likely to determine the evolution of energy
prices. What happens depends both on Russian actions, even absent sanctions,
and on the effect of potential sanctions on Russia’s behavior. In this respect, one
must distinguish between oil (and coal) on the one hand, and gas on the other.

1750 Massachusetts Avenue, NW | Washington, DC 20036-1903 USA | +1.202.328.9000 | www.piie.com

PB 22-5 | APRIL 2022 2

For oil and coal, Russia is a quasi-price taker in a competitive world market. It
faces a very elastic demand curve. For gas, because trade relies on a specific
infrastructure, the market is the EU market, the demand is rather inelastic,
and Russia can be regarded as a quasi-monopolist. This has very different
implications for both the likely behavior of Russia in the absence of sanctions
and the effects of sanctions such as tariffs on prices and Russian exports. Given
technical constraints, a full embargo on gas is not feasible. Tariffs, however, are
feasible, they would be effective, and they should be considered, despite likely
strong effects on consumer gas prices.
Our working hypothesis in the rest of the Policy Brief is that energy prices
are likely to increase relative to their prewar levels, although there is considerable
uncertainty about the size of the increase. So far, both sides have de facto
sheltered oil and gas trade from the fallout from the conflict. The large variations
in the oil market and even more so in the gas market are due to expectations of
Russian actions and sanctions. But the “balance of energy terror” is precarious
and cannot be taken for granted.
We then examine the implications of the war for EU fiscal and monetary
policy. Leaving aside the various sources of spending—from defense to
refugees to the need to adapt the energy infrastructure to a changed supply
of energy—the central fiscal policy issue is, to the extent that food and energy
prices increase, whether and how to offset some of the loss in real income of
households. Two main issues are involved. The first issue is how best to do
it: through subsidies, transfers, or price regulation. The main question here is
how the combination of such measures interacts with embargos or tariffs in
determining the total effects of sanctions, the prices of energy imports, and the
implications for inflation. The second issue is whether these measures, if taken,
should be financed by taxes or by debt. While there is a strong political argument
for levying an exceptional “war” tax, the loss of real income due to the higher
price of imports and the uncertainty associated with the war are likely to lead
to weak aggregate demand; deficit spending may be needed to maintain or at
least limit the decline in output. Debt, even if it ends up higher as a result, will
remain sustainable.
Turning to monetary policy, the standard recipe in response to an increase
in energy or food prices—namely, accommodation of first-round effects and
tightening to limit further effects—must be reexamined. On the one hand, the
additional inflation comes on top of already high inflation, raising the risk of
a deanchoring of inflation expectations. On the other, despite fiscal support,
aggregate demand is likely to be weak and put downward pressure on inflation.
The first effect suggests tightening, the second suggests loosening. For the time
being, the two indeed roughly cancel, which suggests that monetary policy could
roughly remain for the moment on its intended prewar track, but be ready to
adjust one way or the other.
There is, in the current context, an important, and unusual, interaction
between fiscal and monetary policy. The more fiscal policy protects the real
income of workers, the weaker the demand for wage increases is likely to be in
further rounds. The more a decrease in inflation becomes credible, the less the
PB 22-5 | APRIL 2022 3

European Central Bank (ECB) will have to tighten to achieve lower inflation. In
effect, larger deficits can lead to a smaller output cost of fighting inflation.
A final and interesting question is whether this dampening role of fiscal
support could be explicitly taken into account in wage negotiations. During
the pandemic, government-financed furlough- and business-support schemes
socialized income losses and proved a very potent and cost-effective way to
minimize economic and social disruptions. There is a case for a tripartite dialogue
among governments, employers, and employees and, ideally, for a quid pro quo
of wage and price moderation in exchange for significant fiscal support.
Our Policy Brief is organized as follows. We start in section 1 by looking
at the channels through which the war will affect the EU economy. We review
in section 2 the factors likely to determine the evolution of energy prices.
In section 3 we discuss the implications for both output and inflation in the
European Union, and in section 4 the implications for EU fiscal and monetary
policy. We draw conclusions in section 5.

1. ECONOMIC IMPACT OF THE WAR

Nature of the shocks
Our working assumption is that the conflict, which began with Russia’s invasion
on February 24, 2022, will not be resolved in the short term. Over the next
12 months or so, we envision a stand-off, or a Russian occupation with Ukrainian
resistance, or a ceasefire followed by acrimonious negotiations. We posit that
reaching a permanent settlement will take longer.
In this context we assume the following:

• The breach of United Nations principles (which had been observed for three-
quarters of a century on the European continent) will continue to cloud the
horizon and affect confidence beyond the direct effects of the war.
• Most Ukrainian refugees will return to their hometowns, but only gradually as
widespread destruction will prevent their relocation.
• The crisis will result in a lasting increase in European defense spending.
• Coming on the heels of the pandemic, this new shock will lead global firms to
further reconsider their reliance on extended supply chains and just-in-time
delivery schemes.
• The war will affect Ukrainian (and potentially Russian) agricultural crops and
exports, reducing global supply and increasing world food prices.
• Beyond its immediate reaction to the war, the European Union will embark
on an accelerated reduction and the eventual elimination of its reliance
on Russian energy through alternative sourcing, and a faster transition to
renewable energy.
• Sanctions will likely endure and escalate, leading to a substantial decrease
in Russian exports of oil and gas, whether this is triggered by an EU decision
or by a decision of the Russian government to restrict such exports. This is
a major issue, both geopolitically and economically, and we investigate it in
detail in the next section.
PB 22-5 | APRIL 2022 4

A major issue is whether the European Union will continue to respond

in unified fashion to an unfolding crisis. While its common initial response
was strong, divisions have emerged within the European Union on the
appropriateness of sanctions, especially in the field of energy. Decisions on
sanctions are part of foreign policy, where the individual member states of the
European Union have veto power. Energy policy is largely a national prerogative
and the Union does not have the legal means to settle differences by putting
decisions to a qualified majority vote. Our working assumption is nevertheless
that the crisis will eventually trigger common responses and strengthen solidarity
among its members.

Table 1
Main assumptions on the implications of the Russia-Ukraine war for
the European Union

Item Short term (1–2 years) Long term (3–5 years)

Exports, foreign direct Collapse of exports to Russia Restructuring of trade and FDI linkages
investment (FDI), and
Capital losses for European companies
financial linkages

Refugees Large inflow No lasting effect as most refugees are

likely to return or integrate into the labor
Immediate fiscal cost
market.
Fiscal cost of reconstructing Ukraine

Defense Support to Ukraine (weapons) Lasting increases in defense budgets

Efficiency Increased emphasis on resilience

Deglobalization

Confidence Precautionary saving Potential risk premium on Europe, but

also potential drive toward closer policy
integration within the EU

Food prices Significantly higher prices No lasting effect

Spillback from adverse developments in
developing countries

Energy Significantly higher prices Change of sourcing

Supply disruptions Integration at EU level
Additional cost of alternative sourcing Accelerated transition to renewables
(implying additional investment)

Table 1 summarizes our assumptions, distinguishing between short-term and

longer-term effects. In this Policy Brief we focus on short-term implications.
We intend to return to the long-term implications in another brief. Most of the
assumptions are straightforward. Some hypotheses deserve deeper examination:
PB 22-5 | APRIL 2022 5

Exports, foreign direct investment, and financial linkages

Exports to Russia have dropped substantially and are likely to decrease further
as a result of the combination of sanctions by the European Union, restrictions
imposed by the Russian government, and delivery problems. Anecdotal evidence
indicates that, even in the absence of legal restrictions, European firms are
already reluctant to trade with Russia, fearing legal and payment problems.
According to EU trade statistics, exports of goods to Russia amounted to
€89 billion in 2021; if they were to stop—a maximalist assumption—this would
lead, other things equal, to a decrease in aggregate demand for EU goods of
0.6 percent of 2019 GDP.1 A 50 percent reduction in goods exports to Russia
would cut 0.3 percent of GDP off aggregate demand.
The European Union also accounts for three-fourths of foreign direct
investment (FDI) in Russia, for a total of more than €300 billion at end-2019.2
Assuming half of the value of this investment will be lost, this would represent
about 1 percent of EU GDP and less than 2 percent of its stock of outward FDI.
Although significant for several banks and companies, such a loss cannot be
considered to be of major macroeconomic relevance.
During the 2008 global financial crisis, links between financial institutions
played a major role as default by one institution triggered default by some
of its creditors. Although Russia has made visible efforts to meet its external
commitments and stabilize the economy, a default of the Russian government
remains a distinct possibility. The evidence suggests, however, that this is unlikely
to lead to major problems for the EU financial system. Subsidiaries of Russian
banks have already been closed and liquidated without putting the financial
system in danger.
Abstracting from energy and food, imports from Russia and Ukraine are of
minor economic significance. Their interruption may, however, add to the broader
disruption of supply chains due to the pandemic.

Refugees
The flow of refugees has reached 4.6 million people (not counting 7.1 million
displaced persons in Ukraine) at the time of writing, most of them women and
children (UNHCR 2022). The outflow continues (though at a slower pace), so
that 5 million—and maybe more—is a plausible number. This is a human drama of
gigantic proportions and poses major problems of organization and of allocation
across countries. Yet the likely macroeconomic costs appear relatively limited.
Estimates of the annual fiscal cost of providing shelter, food, health care, and
education to refugees vary from €9,000 to €25,000 per person per year.3 On
the assumption of a cost of €10,000 per refugee (per year), the cost of financing

1 Nominal GDP of the EU-27 was €14,017 billion in 2019 (Source: Eurostat).
2 European Commission, Russia fact sheet.
3 See the recent survey by Darvas (2022). The upper estimates are based on Swedish data.
Pisani-Ferry (2022) uses a €10,000 estimate based on the cost of the 2015 wave of refugees to
Germany. Costs are bound to be lower in Poland and other frontline countries than they were
in Sweden. We, therefore, stick to the €10,000 estimate.
PB 22-5 | APRIL 2022 6

5 million refugees for one year is €50 billion, or 0.35 percent of EU GDP. Even
this number overestimates the cost, because within a few months some refugees
will return, some will find work, and some will emigrate from the European Union.

Food
Russia and Ukraine are major producers and, even more relevant, major exporters
of food, wheat in particular.4 According to the Food and Agriculture Organization
(FAO), Russian and Ukrainian exports of wheat accounted in 2019 for 23 percent
of world exports and 7 percent of world production. In Ukraine, planting for the
next harvest may be difficult. Distribution issues, given the fighting in the ports
along the Black Sea, may further decrease exports. The market price of wheat
has already increased nearly 50 percent from $7.70 a bushel before the war to
$11, a level last seen for only a few days in 2008 (Macrotrends 2022).
Because the European Union is a net exporter of agricultural products (in
2021 its trade surplus was close to €50 billion, according to Eurostat 2022), the
global price rise may well improve its terms of trade. Two important caveats are
in order, though. The first is that the loss to EU consumers (as opposed to the
European Union as a whole, i.e., producers and consumers taken together) may
be large, an issue to which we return in section 3. The second is that elevated
food prices are already having dramatic consequences for many emerging-
market and developing countries, affecting their growth and macroeconomic
stability, and potentially affecting the European Union in return.

2. THE ENERGY CONUNDRUM

Much of the economic interdependence between Russia and the European Union
results from the fact that Russia is Europe’s main supplier of fossil fuels. So far,
both sides have mostly refrained from using energy as a vehicle for pressuring
the other. But on April 8, the European Union decided to ban imports of Russian
coal, starting August 22 (Bown 2022). Some EU countries have already gone
further. On March 30, for example, Poland announced its decision to stop
importing any Russian energy by the end of 2022.
In thinking about what may happen to energy prices, as a function of both
Russian decisions and potential sanctions, it is important to distinguish between
oil (and coal) and gas.

Oil and gas

Energy data are easily confusing because of the heterogeneity of measurement
units, so a short summary of the situation is a useful starting point. The supply
of energy in the EU-27 (excluding the United Kingdom) essentially relies on oil
(33 percent, virtually all imported), gas (24 percent, primarily imported), and
coal (12 percent, primarily imported) (figure 1). Other sources include renewables
(domestic), nuclear (essentially domestic, as the fuel itself is a small part of the
total cost), and imported electricity. Russia is a major supplier of oil, gas, and coal.

4 For more detail on the implications of the war for food prices, see FAO (2022). See also Ritchie
(2022).
PB 22-5 | APRIL 2022 7

Figure 1
Primary energy sources, EU-27, 2019

Coal 12%

Natural gas 24%

Other sources 32%

Oil and petroleum products 33%

Source: Authors’ calculation based on Eurostat energy balances. Proportions are based on the energy
content (Terajoules) of the various sources.

Before the war, Russia’s export price closely followed the global market price
for Brent, an indication of high substitutability. Because Russia is one among
many suppliers of oil to the European Union, we assume that lower EU imports
from Russia can be replaced by imports from elsewhere. And lower Russian
exports to the West can be partly offset by purchases by India and China.
Unlike oil, the market for gas is regional. There are, broadly speaking, three
markets globally: Europe, North America, and Asia. Prices on these markets
are related, as liquefied natural gas (LNG) can be shipped to any of them, but
they can differ significantly. Starting in 2021, high demand in Asia led to a major
divergence between the North American gas price and the prices in Asia and
Europe (figure 2).
The relevant market for discussing the impact of an EU sanction is therefore
the European market, not the world market. Gas is basically used in electricity
generation (1/3), by industry and services (1/3), and by households (a smaller
third). It is very substitutable in some of its uses (gas-generated electricity can
be replaced by electricity generated from other sources), much less so for some
others (a gas-powered heating system cannot burn oil or coal). On average,
Russian gas accounts for 8.4 percent of primary energy supply in the European
Union, but there are wide variations across member states. For example, Portugal
does not import any gas from Russia, but in Hungary, Russian gas accounts for
28.5 percent of the supply of primary energy (Pisani-Ferry 2022).
Although not entirely interconnected (Spain and Portugal, for example,
have limited pipeline connections to Northern Europe), price differences in the
European Union can be largely arbitraged away through internal transactions
on imports from the rest of the world, provided—which is not a given—there is
political agreement to do it.5 In what follows, we treat the EU market as one.

5 For example, LNG imports from the rest of the world can be directed to countries where
excess demand is the highest.
PB 22-5 | APRIL 2022 8

Figure 2
Gas prices in Europe, Asia, and the United States, January 2020 to
April 2022
US dollars/million British thermal units
60

50

40

30

20

10

0
Jan Feb Apr Jun Aug Oct Dec Jan Mar May Jul Sept Nov Dec Feb Apr
3 28 24 19 14 9 4 29 26 21 16 10 5 31 25 8
2020 2021 2022
Henry Hub: US gas price
Asian spot price for LNG
TTF: European gas price

LNG = liquefied natural gas; TTF = Title Transfer Facility

Source: Bloomberg.

Thinking about the determination of energy prices

Even absent sanctions, Russia may well want to behave strategically in
determining its oil and gas export policy.
In the case of oil, it may want to increase revenues to finance the additional
spending associated with the war. This would lead to an increase in the world
supply of oil and thus a decrease in the world price. Russia, however, faces a
series of constraints. Additional supply is currently limited by the difficulty of
placing cargoes on the international market (which is reflected in the discount
between the prices of Ural and Brent oil). Moreover, Russia is part of the OPEC+
coalition, which constrains its capacity to increase exports.
In the case of gas, a more subtle effect is relevant. The European Union is
scrambling to reduce its dependence on Russian natural gas, but its commitment
to lowering imports by 2/3 by the end of 2022 is optimistic.6 On the supply side,
some Russian gas can be replaced by gas from Norway, Algeria, and Azerbaijan,
but these countries have limited capacity. The rest must be delivered by ships as
LNG, but in the short run the number of LNG ships is fixed and additional supply
can come only from diverting shipments destined to Asia. On the demand side,
the ability to replace gas by alternative sources of energy is also constrained by
existing equipment.

6 See the European Commission (2022) communication of March 8, 2022.

PB 22-5 | APRIL 2022 9

Recent research (IEA 2022a, McWilliams et al. 2022) concludes that the
European Union cannot, over this year and next, fully replace imports of
Russian natural gas.7 In the short run, then, the EU demand for gas is relatively
inelastic and, under plausible assumptions, the price elasticity of EU demand for
Russian gas (total demand less imports from the rest of the world) may well be
less than one.
Under standard monopoly assumptions, such a low elasticity would lead
Russia to set a very high price, even in the absence of war.8 The reason Russia
did not do so in the past is that the long-run elasticity is surely greater than one,
and so it faces an intertemporal trade-off: A very high price raises revenues in the
short run but decreases them in the long run. The war, however, has two effects
on this computation. The first is an even greater need for higher revenues today,
leading to an increase in the price. The second is that the anticipation of future
sanctions, and the clear decision of the European Union to wean itself off Russian
gas exports, reduces the effects of an increase in the price on future revenues,
again leading Russia to increase the price while the demand is still there.
In short, ignoring sanctions, Russia may want to increase energy export
revenues. But while for oil this would imply increasing the volume of exports
(given the world price), for gas it would imply increasing prices (and therefore
decreasing export volumes). True, long-term gas contracts normally preclude
such behavior, as they specify the indexation of prices on the TTF (Title Transfer
Facility) market price. But Russia has some flexibility to shift part of its supply
from deliveries within the framework of existing contracts to over-the-counter
sales. More fundamentally, contracts can, after all, be revised or broken.
Turning to sanctions, whether embargos or tariffs, the market structure
is again fundamental, and one must discuss separately the effects on oil
and gas exports.

Sanctions: Oil
To sanction Russia, the European Union could emulate the United States and
United Kingdom and declare an embargo on Russian oil. This would be the
most straightforward approach as a European embargo would strengthen the
prevailing reluctance to take part in Russian exports on the part of energy
companies, shipowners, banks, and insurers. Such a measure would not prevent
Russia from exporting altogether—it would find alternative buyers, such as China,
India, or others, as it already does—but an embargo would certainly increase the
discount on Russian oil, as we already see with the Ural price discount relative to
the Brent price, and close to 35 percent at the time of writing. In other words,
the Western strategy would be (it largely is already) to keep Russian oil on the
market, while finding ways to push its price down. If, on net, Russian exports

7 For more discussion of the underlying elasticity of substitution between gas and other sources
of energy, and its implications for GDP if there were a full embargo on gas, see Bachmann et al.
(2022), Baqaee and Moll (2022), and Moll (2022).
8 We think of Russia as a monopolist facing a large number of buyers. In the presence of a
tariff, and coordination among buyers, it may then become more appropriate to think of the
European Union as a monopsonist. In this case, the right conceptual frame is to treat the
outcome as the outcome of a game between the two players. Because European coordination
is still lacking, we have not explored the implications of this alternative way of thinking about
the market.
PB 22-5 | APRIL 2022 10

decreased, the world price would go up, unless the drop in Russian exports
was offset by the decisions of other producers, from Saudi Arabia to Iran to
Venezuela, to increase production.
The rise in the world price would depend, in the end, on Russia’s ability to
find other buyers and on other countries’ decisions to sell more. To get a sense of
how the price impact would depend on the decrease in world supply, it is worth
looking at history.
The 1973 OPEC embargo decreased global supply by 7 percent and led to
an increase in the price of 51 percent. The 1978 Iranian revolution decreased
global supply by 4 percent and led to a price increase of 57 percent. The 1980
Iran-Iraq war decreased global supply by 4 percent and led to a price increase of
45 percent. The 1990 Gulf War decreased global supply by 6 percent and led to a
price increase of 93 percent (Hamilton 2022). Russia accounted in 2019 for about
13 percent of world production and its exports for a similar proportion of world
trade, so a large decrease in Russian supply, not offset by an increase in supply
elsewhere, would have dramatic effects on the price (BP 2021).9
History may not, however, be a reliable guide. The effects of lower supply
depend on the elasticity of both non-Russian oil supply and world demand for oil.
And both are different from what they were in the 1970s or even 1990s.
The price elasticity of supply has increased since the episodes cited above,
especially as the United States has started exploiting shale oil. But it takes time
before new drills start adding to output.
The price elasticity of demand may have declined as oil is increasingly
used where substitutes are lacking, however (for example, for fueling motor
vehicles and airplanes). And government measures to partly protect buyers,
be they firms or consumers, from the price increases may further decrease the
demand elasticity. As discussed in section 4, in late 2021 and again since the
start of the Russia-Ukraine war, several governments have introduced energy-
related transfers and subsidies. To the extent that they affect the price signal,
such measures reduce the demand response. This is of no importance if a small
country subsidizes in isolation: the effect on world demand is too small. But if
many do—and this would be the case if the European Union joined the United
States and the United Kingdom in offering subsidies—the result is bound to be a
larger increase in the global market price.

Sanctions: Gas
The market structure for gas can be viewed as consisting of a monopolist Russia
facing a large number of EU buyers who can purchase gas from other sources
but only at a sharply increasing cost. As we have seen, even in the absence of
sanctions, Russia might want to increase its price and reduce supply. The question
here is what would happen if the European Union decided to use sanctions, most

9 Here and elsewhere, unless specified otherwise, we are using 2019 data as a benchmark,
because 2020 data were affected by the COVID-19 shock and 2021 data are not always
available.
PB 22-5 | APRIL 2022 11

likely through a tariff on Russian exports.10 It would be a strong signal that EU

member states stand ready to jointly confront Russia. A common tariff would
preserve the freedom of private contracts and be legally implementable, as the
European Union (as well as the United States and other countries of the coalition
supporting Ukraine) has revoked Russia’s most favored nation status. We assume
that, in response, private contracts would be either broken or renegotiated.
In that context, the effect of the tariff depends on the elasticity of the net
demand for Russian oil (the demand for Russian gas minus the supply of non-
Russian gas to the European Union). In general, a tariff will increase consumer
prices, but less than one for one; equivalently, it will decrease the pretariff price,
but less than one for one.
In the special case when the elasticity of EU demand is constant, theory
predicts that Russia should keep its (pretariff) price unchanged, leading to a
one-for-one increase in consumer prices and a decrease in demand. Russian
revenues will decrease as demand decreases. In the case of linear demand, the
effect of the tariff on the consumer price will be less than one for one—Russia will
decrease its pretariff price, but less than one for one. Demand will decrease less
than in the constant elasticity case. Russian revenues will decrease because of
lower demand and lower pretariff prices.
Interestingly, a small tariff can actually increase EU welfare: While consumers
pay more, the revenues from the tariffs exceed the extra spending, and so,
properly redistributed, buyers can be better off. The point is nicely made by John
Sturm (2022), who shows the relation to the welfare-improving tariff argument
that is standard in international trade. Larger tariffs will have an adverse effect on
Russian revenues, but also on EU welfare. Assuming linear demand, Daniel Gros
(2022) finds that a 30 percent tariff on Russian gas would actually maximize
EU welfare. Beyond this rate, the tariff would decrease EU welfare but could
substantially reduce Russian revenues. Gros finds that a 60 percent tariff would
reduce Russia’s gas export revenues by three-fourths, but at some welfare cost to
the European Union.

3. COMMODITY PRICE INCREASES, INFLATION, AND REAL INCOME

The previous discussion has made clear that, depending on many factors, both
those affecting Russian decisions and those affecting the choice and intensity of
sanctions, there is substantial uncertainty about the future evolution of oil and
gas prices. We are less pessimistic than the latest joint forecast of the five main
German institutes for economic research (2022), which, in its central scenario,
has the price of Brent reaching $135 per barrel and the price of gas in Europe
roughly doubling to €200 per MWh. In the rest of this Policy Brief we assume—
while realizing the very large uncertainty associated with this assumption—that
Russian decisions and more stringent sanctions will lead to an increase in both oil
and gas prices of 25 percent relative to prewar levels.

10 There is a legal debate, as to whether such an action would require unanimity within the
European Union. Sanctions are decided by unanimity on the basis of Article 29 of the Treaty
on the European Union, but implemented by a qualified majority. Trade policy decisions are
taken by a qualified majority. And in the field of energy, each member state has the right
to determine “the general structure of its energy supply” (Article 194 of the Treaty on the
Functioning of the EU).
 PB 22-5 | APRIL 2022 12

Figure 3
Real price of oil, 1970Q1–2022Q1
index (1990Q4 = 1)
2.5

2.0

1.5

1.0

0.5

0
19 1

19 1

19 1

19 1

19 1

19 1

1
20 Q1

20 Q1

20 Q1

20 Q1

20 Q1

20 1

20 1

20 1

20 1

20 1
20 Q1

1
20 1
1
Q

8Q

Q
Q
Q
72

74

76

78

80

82

84

86

88

90

92

94

96

98

10

12

14

16

18

22
20
70

0
0
0
0
19

19

19
19
19

19
19

19
19

Source: OECD and US Bureau of Labor Statistics via Macrobond. World Brent price deflated by US
consumer price index (CPI).

Commodity prices have increased many times in the past. To take just oil
prices: The Brent price went from $10.27 a barrel in February 1999 to $133 in
July 2008, and then went from $40 in December 2008 to $123 in April 2011. It
remained above $100 until August 2014. Given inflation since 2014, $100 then
would correspond to $120 today, so the current real price of oil has not yet
reached historical records (figure 3).11 As a result, economists have a decent
understanding of the effects of commodity price increases on the economy:

Inflation
The immediate and most visible effect is indeed the effect on inflation. The effect
can be quite large. Electricity, heating fuels, and transportation fuels accounted in
2021 for 9.6 percent of personal consumption expenditures in the euro area, and
food on average represented 15.7 percent of the consumer basket.12 In total, the
share of consumption that is vulnerable to the direct impact of price rises is high.
Empirical estimates generally indicate that the pass-through of commodity
price rises onto consumer prices is partial but quick. A 2010 detailed Eurosystem
study (ECB 2010) found, for an oil price around $100 per barrel, an elasticity of
the energy component of the HICP (harmonized index of consumer prices) to
the oil price of 0.4 (largely because of price-insensitive excise taxes), 90 percent
of which was effective within a month. These estimates are somewhat outdated,

11 FRED data based on US Energy Information Administration.

12 Source: ECB HICP weights for 2021.
PB 22-5 | APRIL 2022 13

however, because they assume an indexation of the gas price on the oil price
(which has been discontinued) and rigidity of the electricity price (which does
not hold anymore) (ECB 2010, table 9).
Let us then take 10 percent for the share of energy in private consumption
and assume a 50 percent pass-through. The direct impact of the assumed
25 percent rise in prices is thus 25 percent × 0.1 × 0.5 = 1.25 percent. For food, let
us assume a 15 percent share, a 10 percent increase, and also a 0.5 pass-through.
The impact is 10 percent × 0.15 × 0.5 = 0.75 percent. This implies a 2 percent
initial increase in the cost of a consumption basket.
These first-round effects can hardly be avoided, but they are just the
beginning. Subsequent rounds reflect the responses by firms and workers.
Producers of goods that use energy or agricultural products as an input increase
their prices to reestablish their markups. Workers whose wages lagged consumer
prices in the first round ask for nominal wage increases to reestablish their real
wage. These lead to further increases in prices and wages. The strength of these
further rounds depends on how hard firms try to reestablish markups, and how
hard workers try to maintain their real wage. Eventually, if commodity prices
remain high, the pressure on inflation stops only when either the firms that use
these commodities accept lower markups and/or workers accept lower real
wages. As we shall see, what happens to inflation and activity over time then
depends on both monetary and fiscal policy, as we discuss later.

Real income
These inflation dynamics are present whether or not an economy produces
or imports these commodities. But whether the economy is a net importer or
not makes an important difference to what happens to aggregate real income.
Take the case of the United States, which roughly covers its energy needs
domestically. An increase in the price of energy is reflected in a decrease in the
real income of energy users (consumers and firms) and an increase in the real
income of energy producers (and their shareholders). The effect on the US real
income as a whole is roughly equal to zero. The effect on aggregate demand
depends on both energy users’ and producers’ marginal propensity to spend,
and so may go up or down. The European Union, however, imports nearly all the
gas and oil it consumes, so an increase in prices leads to a decrease in the real
income of energy users and an increase in the real income of foreign producers,
who are unlikely to spend much on EU goods. Thus a price increase in these
commodities is likely to have a large adverse effect on domestic demand. In both
cases, energy users, especially consumers, may be worse off. But the effect on
aggregate demand depends on whether the country is a net importer or not.
It is useful to think about the implications of both oil and gas price increases
for the EU real income and get a sense of magnitudes.
Start with oil. Oil markets appear to assume that the reduction in global
supply will be limited. The Brent price was $99 per barrel the day before the
war started, up from $78 at the start of 2022; it went briefly up to $133 but, at
the time of writing (April 14, 2022), was down to $110.13 Assume an increase
in the price from $78 to $100, roughly 25 percent. Imports of oil (from Russia

13 Crude oil prices (Brent) from FRED.

PB 22-5 | APRIL 2022 14

and elsewhere) by the EU-27 were equal to 5,900 million barrels in 2021. Such
an increase in price would imply a decrease in real income for the European
Union of 5,900 × 22 / 1.1 (for the dollar-euro exchange rate), thus €118 billion, or
0.84 percent of 2019 GDP.14
Gas markets have also retreated from the elevated prices of February, but
they remain high. Assume that the percentage increase in the average price of
gas for the European Union is the same as for oil, about 25 percent. Imports of
gas (from Russia and elsewhere) were equal to €170 billion in 2021. This implies
a decrease in real income for the European Union of 170 × 0.25 ≈ €42 billion, or
0.3 percent of 2019 GDP.
Under these fairly moderate assumptions, the war-induced increase in oil and
gas prices would take a little more than 1 percent of GDP off the real income of
the European Union. But this would come on top of the effect of previous price
hikes since 2019. Overall—and disregarding the lockdown period in 2020 during
which prices and quantities collapsed—EU imports of energy, which amounted
to 2.6 percent of GDP in 2019, would have exceeded 5 percent of GDP had prices
remained at their early 2022 level, and would increase to more than 6 percent
based on our assumptions.

Distribution effects
Beyond the aggregate loss of real income for consumers, distribution effects
are important. Consumption of gas, utilities, and food (as a share of total
consumption) is higher for low-income than for high-income households—although
there are clear differences across countries: Based on Eurostat data, the difference
is small in Scandinavian countries, for example, 26 percent for the bottom income
quintile versus 25 percent for the top quintile in Denmark. It is larger for France
and Germany, 25 percent versus 21 percent in France, 26 percent versus 21 percent
in Germany. It is even larger for poorer countries, for example, 31 percent versus 23
percent in Spain, and 50 percent versus 37 percent for Bulgaria.15,16
Moreover, the consumption patterns of lower-income households are often
more rigid, as a larger part of their income is preallocated to rents and other
monthly payments they cannot easily modify. Thus, apart from the aggregate
effects on output and inflation, one must take into account that poor households
suffer more than richer ones from an increase in commodity prices. This has clear
implications for fiscal policy.

14 Source for oil imports: Energy balances, Eurostat.

15 These numbers are constructed as the ratio of food consumption (CP01) plus electricity,
gas, and other fuels (CP045) plus operation of personal transportation (CP072) to total
consumption, for each quintile. Numbers are from Eurostat-data.xlsx.
16 Some of the numbers that have been published appear much higher. For example, BLS data
for the United States for 2020 give a ratio of consumption of food, transport, and utilities to
disposable income of 74 percent for the bottom quintile versus 20 percent for the top quintile.
But this reflects, partly, different definitions of what is included in the smaller consumption
basket and, mostly, the fact that the analysis looks at the ratio of consumption of gas, utilities,
and food to disposable income rather than to consumption. In the lower quintile are many
individuals and households who are dissaving and for whom disposable income is small relative
to consumption.
PB 22-5 | APRIL 2022 15

4. IMPLICATIONS FOR POLICY

We finally turn to the fiscal and monetary policy responses. In the short run, the
main issue, and the source of potentially large spending, is whether and how to
protect consumers from the commodity price increases.

Tax and transfer measures

Under our moderate price increase assumptions, the median increase in the price
of the consumption basket, given wages, is about 2 percent.17 But the decrease
in real income for the lowest income quintile in the most affected countries
(e.g., Slovakia) is twice as high, 4 percent. This is a very large number, knowing
that the dispersion of income effects among households even within an income
bracket can be very large, depending on living conditions, and recognizing that
the increases in commodity prices may be larger than in our assumptions.18
The question, then, is how much and how best to protect households.
Since energy prices started to ratchet up in late 2021, EU member states have
been busy introducing a series of schemes intended to soften the shock. These
schemes can be grouped under three headings.19
Temporarily lower energy taxes. A first possibility is direct across-the-board
subsidies, for example, in the form of cuts or rebates on energy taxes, which are
high in most EU countries. France, for instance, introduced in February a 1-year
cut in electricity taxes (at a cost of €8 billion or 0.3 percent of GDP) and on
April 1 a reduction of gasoline taxes of 15 cents per liter for a period of 4 months,
at an estimated cost of €2.2 billion, about 0.1 percent of GDP.20 This subsidy is
presented as an emergency stopgap until a more targeted system is introduced
in early summer. It is highly visible, a political advantage. Similar temporary cuts
to excise taxes have been introduced elsewhere, notably in Germany where, on
March 23, the gasoline tax was lowered by 30 cents per liter.21
Lump-sum transfers. An alternative approach is to provide transfers that are
independent of the consumption of food, oil, and gas. Germany, for example,
introduced on March 23 a universal lump-sum transfer (Energiepreis-Pauschale)
of €300 per person plus supplements for children. France introduced last year
an indemnité inflation of €100, given automatically to people with an income no
higher than €2,000 a month, at a cost of €3.8 billion, or about 0.2 percent of
GDP.22 Such measures are unlikely to affect market prices for food, oil, and gas
substantially (only to the extent that the additional income is spent on these

17 Building on the previous discussion of inflation, to the extent that final goods producers do not
fully reflect the increase in commodity prices and accept a decrease in their markup, the effect
in the initial round will be smaller than the number in the text. But, if they reestablish markups
over time, the number in the text is the relevant one.
18 In the French case, Douenne (2019) provides evidence on the vertical and horizontal
dispersions of the effects of a carbon tax.
19 In October 2021 the European Commission introduced a Toolbox of measures to tackle the
energy situation, as feasible options for member states to consider.
20 For details about the French measures, called bouclier tarifaire, see Gouvernement français
(2022).
21 See the March 23 German government measures. Another set of measures in support of
affected business was introduced April 8.
22 This payment was introduced in 2021, thus before the Russia-Ukraine war, to offset the already
large increase in many commodity prices in 2021.
PB 22-5 | APRIL 2022 16

goods), and thus have the effect that the transfers go mostly to consumers rather
than commodity producers.
There may be feasible schemes to target transfers more accurately to better
protect those who both have a low income and spend more of it on food, oil, and
gas. For example, in the case of electricity, one might make transfers proportional
to a recent utility bill and, combining it with household income information,
limit it to those with income below some threshold. Or gasoline checks—a given
amount of money to be spent only on energy or gasoline—might be issued;
indeed, an energy check exists in France and a gasoline check is being discussed
in the United States. To the extent that the check is less than what the recipient
spends on energy, this measure does not affect the marginal price s/he faces
and thus does not affect incentives to reduce energy consumption. Its political
acceptability may however be lower than for across-the-board subsidies.
Price regulations. Yet another approach is to decouple some prices, such as
the electricity price, from their marginal cost. The issue has become particularly
salient in the face of extremely large fluctuations in the market price of natural
gas—which is the relevant marginal cost in the production of electricity. Spain
especially has been vocal in criticizing the inflationary effect of electricity pricing,
and in March it obtained EU authorization to temporarily disconnect the Iberian
Peninsula from the EU electricity market. France has asked the country’s main
electricity company to limit the price increase to 4 percent for 2022 and to
satisfy demand at that price, thus asking the company to absorb a large part
of the cost, leading to a large anticipated decrease in cash flows and a large
decrease in market value. This entails an inefficiency, as the price is less than
marginal cost, but allows for a potentially large increase in consumer surplus—at
the cost of a larger decrease in producer surplus. From a welfare viewpoint, the
gain in real income of consumers may well dominate the loss in efficiency.23

Potential perverse effects of subsidies

Two main objections can be raised against subsidies. The first is that they increase
the demand for energy, thus contributing to keeping energy prices high.24 The
issue is familiar from the standard discussion of tax incidence. Consider subsidies
to the various uses of oil. The effect on consumer prices depends on what happens
to the market price of oil. If only one country uses such subsidies and it is small
relative to the world market, the world market price will not change and thus the
subsidy will be reflected one-for-one in a lower consumer price. If, however, all
EU countries, and possibly other countries such as the United States, introduce
such subsidies, then the relevant supply curve is the world supply curve, which is
inelastic in the short run. In the extreme, if the supply curve is fully inelastic, the
effect will be to increase the market price one for one and leave the consumer

23 For more on the measures taken by EU members, including subsidies, transfers, and price
regulations, see Sgaravatti, Tagliapietra, and Zachmann (2022).
24 They also go against the need to decarbonize the energy system.
PB 22-5 | APRIL 2022 17

price unaffected.25 In other words, the subsidies will go to the oil producers,
including Russia. In practice, the outcome is likely to be less than a one-for-one
effect of subsidies on market prices, but it is still unappealing.
The second, more specific but highly relevant objection, is whether subsidies
may go against a possible future tariff and actually strengthen Russia’s hand in
its confrontation with the European Union. As discussed in the previous section, a
tariff on gas would lower both the price and the volume of Russian exports, while
the corresponding revenues could be used to soften the impact on consumers.
The question, however, is how this subsidy should be designed. A direct domestic
gas price subsidy, such as a lowering of indirect gas taxes, would increase the
demand for gas and the price charged by Russia, countering the effects of tariffs.
Governments should not use the revenue from a tariff on Russian gas to subsidize
energy consumption in a way that lowers the marginal price of gas on the
European market. They should rather rely on transfer schemes that do not affect
the marginal price.

Taxes versus debt finance

The next question is by how much fiscal measures should be financed through
additional taxes versus debt finance. Tariff revenues may help, but, as we
discussed earlier, tariffs are unlikely to yield much revenue for oil; they are likely
to yield more in the case of gas.
Immediate discretionary fiscal spending essentially consists of defense
procurements (including for the provision of weaponry to Ukraine), assistance to
refugees, measures in support of households, and emergency investments to adapt
the energy system. Under our price assumptions, fiscal costs range from small to
manageable: In 2022 they should not exceed one-sixth of a percentage point of
EU GDP for defense, one-third for assistance to refugees, and, depending on the
decisions of different member states, between half and a full percentage point for
measures in support of households.26 A more challenging question is how much
emergency energy investments may cost. We do not have a good estimate but
assume that it should not exceed half a percentage point. Altogether, therefore, the
discretionary fiscal cost of the war should remain within 1.5 to 2.0 percent of GDP.
This would be less than half the fiscal cost of the pandemic support measures,
which in Europe typically amounted to 4 percent of GDP in 2020.
Should this additional spending be financed through taxes or debt?
On traditional public finance grounds, there are good arguments for relying
partly on debt finance. Part of the increase in spending is likely to be temporary,
thus justifying tax smoothing.
On political economy grounds, the notion of a war tax—a “Putin tax,” as
President Biden has called it in the United States, although he was referring to
the decrease in real income rather than an explicit tax—may be less unpopular
than in other circumstances and underscore the point that contrary to current
perceptions in Western Europe a war, even an economic war, is not free.

25 The slope of the supply curve was the subject of a Twitter discussion between Paul Krugman
and Jason Furman (https://twitter.com/jasonfurman/status/1496483717027618826?s=20&t=Q1
d9GIf5i7J1c9T9XaI0UA).
26 The German support program consists of two packages of about €15 billion each.
 PB 22-5 | APRIL 2022 18

On macroeconomic stabilization grounds, the case for relying largely on debt

finance is strong. The decrease in real income for the European Union is large
and is likely to lead to lower consumption. Export demand from Russia is likely
to be drastically lower. Higher uncertainty, which played a large role in reducing
consumption and investment during the COVID-19 crisis, may play a substantial
role again. Fiscal support and reliance on debt finance rather than on a tax
increase to offset the higher spending are likely to be needed.27
This raises the standard question about debt sustainability (a question one
of the authors has addressed at length in other writings).28 While it may well be
that slowing inflation will require temporarily higher real interest rates, the factors
behind low neutral real rates have not changed, and—provided inflation remains
under control, so that the inflation risk does not start being priced in real bond
rates—the neutral rate should, after a bump, remain low in the medium run. The
evidence so far is that 10-year benchmark bond rates have increased by 50 basis
points only since the start of the war, a limited upward adjustment in view of the
magnitude of the geopolitical and economic shock (figure 4).

Figure 4
Euro area yield curves, February 11 and April 13, 2022
yield in percent
2.0

1.5

1.0

0.5

–0.5

–1.0
3 6 9 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Months Years
AAA rated: February 11, 2022 AAA rated: April 13, 2022
All bonds: February 11, 2022 All bonds: April 13, 2022

Note: The solid lines show the yield curve for AAA-rated sovereign bonds only. The dotted lines show the
same for all euro area sovereign bonds.
Source: European Central Bank, https://www.ecb.europa.eu/stats/financial_markets_and_interest_rates/
euro_area_yield_curves/html/index.en.html.

27 It is interesting in this respect that Germany decided to combine both approaches by financing
a defense fund through debt at 3 percent of GDP, while committing to finance the permanent
increase in military spending through taxes.
28 Olivier Blanchard, Fiscal Policy Under Low Interest Rates (forthcoming 2023, MIT Press).
PB 22-5 | APRIL 2022 19

In the short run, debt dynamics are likely to remain extremely favorable.
ECB (2022a) March forecasts of euro area real GDP growth, nominal policy
rates, and inflation for 2022 are 3.7 percent, 0.8 percent (for the 10-year yield),
and 5.1 percent. This implies a value for (r − g) of (0.8 percent − 5.1 percent −
3.7 percent) = −8 percent.29 Combined with a debt ratio of 98 percent, this would
allow EU governments as a whole to run primary deficits of 8 percent while
keeping debt ratios constant. Thus, there is substantial room to run temporary
larger deficits if needed.

Monetary policy
The typical advice to a central bank hit with an increase in commodity prices is
to accommodate first-round effects (it cannot do much about those anyway)
and limit subsequent-round effects, if necessary through lower output and higher
unemployment, until inflation is back to target (Blanchard and Galí 2007).
One can expect firms to eventually reestablish their markup. Thus, how much
the central bank needs to lean in and slow activity depends very much on the
behavior of wages. Having suffered a decrease in their real wage in the first
round, workers will want to catch up and will ask for a nominal wage increase.
And if they expect inflation to remain high, they will ask for higher nominal
wage growth in addition. The strength of this first effect, workers’ desire to
catch up, depends, among other factors, on how much of a decrease in real
income they suffer in the first round and how strong they are in bargaining,
thus on the tightness of the labor market. The strength of the second effect,
expected inflation, depends on the credibility of the central bank strategy and its
commitment to return inflation to its target.
There is in this context an important interaction between fiscal and monetary
policy. To go back to the various protection measures governments may use:
Price subsidies—to the extent that they mechanically reduce the increase
in consumer prices—or price ceilings (as in the case of the delinking of the
electricity price from its marginal cost) decrease first-round inflation and thus
limit the initial decrease in the real wage. This in turn decreases wage pressure
in subsequent rounds, making it easier for the ECB to reduce inflation over time.
Transfers do not affect first-round inflation, but they limit the initial decrease in
real income, thus potentially reducing wage pressure in second and subsequent
rounds. To put it strongly, more protection and higher deficits reduce the need to
tighten monetary policy to return inflation to its target.
There is therefore a clear trade-off: From an efficiency perspective as well
as to ensure the effectiveness of sanctions, governments should avoid income
support measures that weaken the price signal and may in fact benefit Russia.
But from an inflation control perspective, they should rely on measures that
have a direct, measurable impact on consumer prices. Some measures qualify on
both accounts (as indicated, this is the case of transfers based on past energy

29 The ECB also gives two other scenarios, one adverse and one severe. In the severe scenario,
growth is 2.3 percent, the 10-year yield is 0.8 percent, and inflation is 7.1 percent, implying a
value for (r – g) of –8.6 percent.
PB 22-5 | APRIL 2022 20

consumption, if the lower average price paid by consumers is reflected in the

construction of the CPI, which in principle it is). But many of the measures
introduced so far do not pass the test.

Tripartite wage discussions

One can go a step further and make the case for tripartite discussions, if not
negotiations, between firms, workers, and the state. So long as commodity
prices remain higher, real wages and/or markups must be lower. As we have
discussed, the state can limit the decrease in the real income of workers through
subsidies, transfers, and price regulations, financed by a mix of taxes on the
better off, or debt finance, shifting some of the burden to future taxpayers.
Inflation is an extremely inefficient way of reaching an outcome, relying on either
workers or firms to give up and accept lower real wages or lower markups. A
negotiation in which workers, firms, and the state agree on a better outcome
and, by implication, smaller second and subsequent rounds of inflation is
clearly desirable.
Is it achievable? The role of such social negotiations has long been
debated, and the usual answer is that it requires an unrealistic degree of
coordination across firms and across unions. This time may be different,
and tripartite negotiations, or at least discussions, should be an option that
governments consider.
Any success in reducing the size of second-round effects allows for a more
relaxed monetary policy. Two other factors are relevant here, although they move
desirable monetary policy in opposite directions.

Potential deanchoring of expectations

The inflation due to the commodity shock comes on top of an inflation rate
substantially higher than what was forecast for 2021. Even before the war, this
had led to concern about a deanchoring of inflation expectations, which would
make the job of the ECB more difficult.
Based on the ECB Survey of Professional Forecasters (ECB 2022b), long-
run expectations of inflation have started to increase, with the average forecast
going from 1.8 percent at the start of 2021 to 2.1 percent in April 2022 (Lane
2022).30 This was initially a welcome development after years during which
inflation was expected to undershoot the target, but the worry now is that the
additional first-round inflation due to the war will lead to outright deanchoring.
As recently pointed out by Isabel Schnabel (2022) of the ECB Board, this argues
for a tougher monetary policy stance in subsequent rounds than would be the
case in the absence of higher previous inflation.

Potential weakness of private demand

The other relevant factor is the effect of the war-related shocks on aggregate
demand. The reduction in real income even partly compensated by subsidies and
transfers, diminished exports, investment losses, and a dent in overall confidence

30 The increase from 1.8 to 2 percent was desirable; the issue is whether it would stop there.
PB 22-5 | APRIL 2022 21

are good reasons to think that, even with fiscal support, aggregate demand
will be weaker, apart from any monetary tightening. This suggests less need for
tighter monetary policy than was the case before the war and, other things equal,
argues for looser monetary policy.
Which of these factors will dominate and whether ECB monetary policy
will have to be tighter or looser than was intended before the war is difficult to
assess at this point. The size of the shocks, the strength of second-round effects,
the anchoring of inflation expectations, and the weakness of aggregate demand
are all uncertain. Markets have a hard time assessing what the net effect should
be on monetary policy: The euro yield curve went sharply down as the war
started, but is now a bit higher than before the war (see figure 4).31 The current
ECB stance of no major adjustments due to the war appears to be the right one
at this point.32 But the ECB will have to adjust its stance and be unusually nimble
to avoid either lasting inflation or a recession.

5. CONCLUSION
For Europe, the war in Ukraine is a first-order economic shock. While the direct
fiscal implications of taking care of refugees, increasing military spending, and
strengthening energy autonomy remain limited, the impact of elevated energy
and food prices on national income and its distribution is potentially large. It
would get larger if future European sanctions affect the global oil market or the
supply of gas to the EU market. This raises three macroeconomic challenges
for policymakers.
The first is how best to use sanctions to deter Russia while limiting adverse
effects on the EU economy. In this respect, it is important to distinguish
between oil and gas. For oil, Russia can diversify away from the EU market and,
despite sanctions, sell on the world market where it operates as a price taker.
The implications are that the spillback from EU sanctions is global and that a
European embargo or tariffs on oil may have limited effects on consumer oil
prices. For gas, the European Union has substantial leverage because Russia
is almost completely dependent on the pipeline infrastructure linking it to the
European market. But because supply from other sources is relatively inelastic,
Russia faces a sharply downward sloping demand curve and enjoys significant
market power. Given technical constraints, and this strategic game, an embargo
on gas is not feasible. Tariffs, however, are feasible; they would be effective, and
they should be considered, despite likely strong effects on consumer gas prices.
The second challenge is how to deal with the decrease in real income due
to the increase in the energy import bill. Here, two issues require policy clarity.
First, if governments want to partly protect buyers—consumers and firms—
from the increase, they have choices among measures, from direct subsidies to
targeted transfers, regulations, and price caps. For gas and to a lesser extent
oil, subsidies—especially across-the-board tax cuts—may partly offset the
effect of sanctions and as such are undesirable. Lump-sum transfers that do
not affect the marginal price, and consequently do not diminish incentives to

31 See, for example, the ECB’s yield curves for February 23, March 3, and March 17.
32 We thus largely agree with the analysis and conclusions of Isabel Schnabel (2022) in her
April 2 speech.
PB 22-5 | APRIL 2022 22

reduce demand, are preferable, especially if directed to low-income and other

most affected households. Second, governments must decide how to finance
the extra spending. Because some of the spending is temporary and because of
uncertainty, the loss of real income, and lower exports to Russia, all leading to
weak aggregate demand, fiscal support and thus some additional deficit finance
may be needed. Even if deficits are larger, given high inflation and the still low
nominal rates, debt ratios are likely to decrease over the next one or two years,
and debt will remain sustainable.
The third macroeconomic challenge is how to deal with the increase in
inflation as a result of higher energy and food prices. Two forces are at work.
The first is the need to avoid a deanchoring of inflation expectations, more of
a challenge than usual given that inflation had already substantially increased
before the war. Preventing this risk would call for a tightening of monetary policy.
The second factor is that the loss of real income is likely to lead, even with some
fiscal offset, to weaker aggregate demand, implying a need to loosen policy.
The challenge for policymakers is to cope with these conflicting objectives. In
this context, policy instruments complement each other. A combination of well-
designed fiscal support to households and tripartite wage discussions may help
to soften the trade-off that the central bank is facing.
In each of these three dimensions, there is considerable uncertainty as to
the outcome. Energy prices may increase much more than they have so far, or
instead return to prewar levels. By implication, the loss in real income and the
inflationary pressure may be much larger, or instead be less of an issue than
currently forecast. This leads to our last conclusion. Fiscal and monetary policy
should be nimble, consisting of measures easy to adjust as the need may be.

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