Sanctions, Substitution, and the Informal Margin: Geoeconomic Spillovers in Eastern Europe

This paper uses a two-sector general-equilibrium model to analyze the impact of trade-restricting sanctions on Eastern European economies. We identify a mechanism of informal leakage: as import prices rise, firms substitute sanctioned inputs with unregulated domestic alternatives. This expands the shadow economy, depressing productivity and eroding fiscal capacity. Calibrating the model to high-exposure frontier states (the Baltics and Finland) versus a lower-exposure Balkan control, we find frontier economies suffer disproportionate fiscal erosion. Consequently, sanction regimes may require compensatory transfers to preserve allied states’ institutional integrity.