Rare Disasters, the Natural Interest Rate and Monetary Policy

55 Pages Posted: 14 Apr 2021

Date Written: December 22, 2020

Abstract

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.

Keywords: rare disasters, natural disasters, natural interest rate, climate change, DSGE, monetary policy

JEL Classification: E4, E5

Suggested Citation

Cantelmo, Alessandro, Rare Disasters, the Natural Interest Rate and Monetary Policy (December 22, 2020). Bank of Italy Temi di Discussione (Working Paper) No. 1309, Available at SSRN: https://ssrn.com/abstract=3826379 or http://dx.doi.org/10.2139/ssrn.3826379

Alessandro Cantelmo (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

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