Rare disasters, the natural interest rate and monetary policy

By Alessandro Cantelmo

http://d.repec.org/n?u=RePEc:bdi:wptemi:td_1309_20&r=dge

This paper evaluates the impact of rare disasters on the natural interest rate and macroeconomic conditions by simulating a nonlinear New-Keynesian model. The model is calibrated using data on natural disasters in OECD countries. From an ex-ante perspective, disaster risk behaves as a negative demand shock and lowers the natural rate and inflation, even if disasters hit only the supply side of the economy. These effects become larger and nonlinear if extreme natural disasters become more frequent, a scenario compatible with climate change projections. From an ex-post perspective, a disaster realization leads to temporarily higher natural rate and inflation if supply-side effects prevail. If agents’ risk aversion increases temporarily, disasters may generate larger demand effects and lead to a lower natural rate and inflation. If supply-side effects dominate, the central bank could mitigate output losses at the cost of temporarily higher inflation in the short run. Conversely, under strict inflation targeting, inflation is stabilized at the cost of larger output losses.

I mentioned several times on this blog that demographic aging is a source of declining interest rates. Now add climate change to the mix. As it looks like declining fertility may also come from climate change, the two shocks may reinforce each other in reducing interest rates. After a decade or two with interest rates kept low by policy, they may not be increasing that much once we get back to “normal” times.

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