The Economic and Policy Consequences of Catastrophes: What is the likelihood that the US will experience a catastrophic event?

Abstract (via MIT.edu)

What is the likelihood that the U.S. will experience a devastating catastrophic event over the next few decades – something that would substantially reduce the capital stock, GDP and wealth? What does the possibility of such an event imply for the behavior of economic variables such as investment, interest rates, and equity prices? And how much should society be willing to pay to reduce the probability or likely impact of such an event? We address these questions using a general equilibrium model that describes production, capital accumulation, and household preferences, and includes as an integral part the possible arrival of catastrophic shocks. Calibrating the model to average values of economic and financial variables yields estimates of the implied expected mean arrival rate and impact distribution of catastrophic shocks. We also use the model to calculate the tax on consumption society would accept to reduce the probability or impact of a shock.

Introduction (Via Mit.edu)

What is the likelihood that the U.S. will experience a devastating catastrophic event over the next few decades? Even if the probability is small, what does the possibility of such an event imply for the behavior of economic variables such as capital investment, interest rates, and equity prices? And how much should society be willing to pay to reduce the probability or the likely impact of such an event?
By “catastrophic event,” we mean something national or global in scale that would substantially reduce the capital stock and/or the productive efficiency of capital, thereby substantially reducing GDP, consumption, and wealth. Examples that we have in mind (you can come up with your own) include a nuclear or biological terrorist attack (far worse than even 9/11), a highly contagious “mega-virus” that spreads uncontrollably, a global environmental disaster, or a financial and economic crisis on the order of the Great Depression. Unlike more locally contained events such as Hurricane Katrina or the recent Asian tsunami, as terrible as they were, the events of concern to us would destroy part of the country’s (or the world’s) productive capital and raise future costs of operating the remaining capital.1Our approach to analyzing the economics of catastrophes differs considerably from the existing literature. We do not try to estimate the mean arrival rate and impact distribution of catastrophic events from historical data, nor do we use the estimates of others. Instead, we develop an equilibrium model of the economy and estimate these characteristics as a calibration output of our analysis. In effect, we are assuming that the calibrated characteristics of catastrophes are those perceived by firms and households, in that they are consistent with behavior, and thus with the data for key economic variables.

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