Defense spending, cost of living, and the optimal exchange rate regime during wartime in Ukraine

Were either the exceptional defense spending needs of the government or the sharp increase in the cost-of-living of poorer households factors that rationalize the National Bank of Ukraine’s temporary fix of the Hryvnia when Russia invaded in 2022? To test the validity of these explanations, we develop a small open-economy two-agent New Keynesian (SOE-TANK) model of Ukraine featuring: (1) a government that finances military imports and (2) low- and high-income households. We find that the surge in foreign-currency-denominated military spending alone does not justify a temporary exchange-rate peg. However, when the consumption of lowincome households is close to subsistence levels, we find that the optimal exchangerate regime becomes state-contingent: exchange-rate flexibility is desirable for small shocks, whereas for a large-scale invasion shock, a fixed exchange rate dominates a floating regime with a standard Taylor rule.