Monetary Policy and Natural Disasters in a DSGE Model: How Should the Fed Have Responded to Hurricane Katrina?

Abstract

In the immediate aftermath of Hurricane Katrina, speculation arose that the Federal Reserve might respond by easing monetary policy. This paper uses a dynamic stochastic general equilibrium (DSGE) model to investigate the appropriate monetary policy response to a natural disaster. We show that the standard Taylor (1993) rule response in models with and without nominal rigidities is to increase the nominal interest rate. That finding is unchanged when we consider the optimal policy response to a disaster. A nominal interest rate increase following a disaster mitigates both temporary inflation effects and output distortions that are attributable to nominal rigidities.

Keywords: Optimal Monetary Policy, Nominal Rigidities, Natural Disasters, Hurricane Katrina

JEL Classification: E31, E32, E42