Navigating Climate Shocks: The Macroeconomic and Financial Stabilizing Role of Government-Led Resilience Investments

Abstract

The increasing frequency of extreme climate events poses a growing threat to economic stability. This paper develops a New Keynesian Environmental Dynamic Stochastic General Equilibrium (NK-E-DSGE) model that integrates brown and green firms, climate shocks, and green financial stabilizers embedded within the financial sector. Using this framework, we assess the macroeconomic effects of climate shocks, examine their transmission channels, and further analyze the role of resilience investments in mitigating these adverse impacts. Our findings show that climate shocks reduce investment and aggregate output, damage banks' net asset position, and increase systemic financial risks, although they simultaneously lower carbon emissions to some extent. Further mechanism analysis indicates that green financial stabilizers effectively mitigate the adverse transmission of climate shocks by slowing the speed of asset adjustments, appropriately raising risk premiums, and tightening credit constraints. In contrast, inadequate market mechanisms may exacerbate supply-demand mismatches, amplifying the economic disruption caused by climate shocks. In addition, resilience investments play a significant role in restoring damaged capital and accelerating post-disaster economic recovery. However, these investments may crowd out private investment and household consumption, and could even lead to increased carbon emissions. Our analysis further demonstrates that coordinating resilience investments with accommodative monetary policy can mitigate these crowding-out effects and substantially enhance the pace of economic recovery.

Keywords: Climate Shocks, DSGE Model, Environmental economics, Resilience Investments