Disaster risk and preference shifts in a New Keynesian model

Abstract

This paper analyzes the effects of a change in a small but timevarying "disaster risk" à la Gourio (2012) in a New Keynesian model. In a real business cycle framework, the disaster risk has been successful in replicating observed moments of equity premia. However, responses of macroeconomic variables critically depend on the value of the elasticity of intertemporal substitution (EIS). In particular, we show here that an increase in the probability of disaster causes a recession only in case of an EIS larger than unity, which may be arbitrarily large. Nevertheless, we also find that incorporating sticky prices allows to conciliate recessionary effects of the disaster risk with a plausible value of the EIS. A higher disaster risk is then also associated with an increase in the discount factor and with deflation, making it consistent with the preference shock literature (Christiano et al., 2011).

Changes in Natural Disaster Risk: Macroeconomic Responses in Selected Latin American Countries

“…Third and most importantly, empirical evidence is sufficiently important for some of the model parameters required in the theoretical simulation exercises presented here. In particular, the elasticity of intertemporal substitution and the degree of price stickiness play a key role in the responses, as explained in Isoré and Szczerbowicz (2017). These parameters are well documented for this group of countries, unlike for example South-Asian countries of similar income levels (see Subsection 4.1).…”

“…Gabaix (2011), Gabaix (2012), and Gourio (2012) have introduced a small but time-varying probability of disasters in real business cycle models, and find that changes in the probability of disasters, without any arrival of the disaster itself, may suffice to trigger economic recessions. Isoré and Szczerbowicz (2017) further showed how to extend this approach to a New Keynesian environment, and found that disaster risk shocksn-again, absent of actual disaster realization-, generate procyclical responses of consumption, investment, labor, wage, and inflation, simultaneously to the recession and rise in equity premium. Further empirical evidence by Siriwardane (2015) and Marfè and Penasse (2017) support the relationship between changes in the probability of a disaster and macroeconomic variables.…”

“…In this paper, changes in disaster risk are simulated for five Latin American countries-namely Argentina, Brazil, Chile, Colombia, and Mexico-using variants from the New Keynesian DSGE model developed by Isoré and Szczerbowicz (2017). This study is the first analysis of the effects of changes in disaster risk, absent of actual disaster occurrence, in the particular context of emerging economies.…”

“…Section 2 presents some evidence on natural disasters in the five countries of interest, regarding their frequency, type, and size in particular. Section 3 summarizes the model by Isoré and Szczerbowicz (2017), a New Keynesian DSGE model which embeds a small but time-varying probability of disaster. Section 4 discusses how calibration accounts for country specificities and shows the responses of macroeconomic variables to a 1% change in disaster risk.…”

“…It compares country-specific variants of the New Keynesian model with disaster risk developed by Isoré and Szczerbowicz (2017). Countries with higher price flexibility, such as Argentina, Brazil, and Mexico, are found to be relatively less vulnerable to disaster risk shocks, as compared to Chile and Colombia in particular.…”