The Macroeconomics of Rare Events

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The Macroeconomics of Rare Events

Postby Anup V » Fri Jul 13, 2012 12:53 am

People in developing countries are more often affected by rare events, such as natural disasters and epidemics, than people in developed nations. Furthermore, the intensity of these events is usually higher in poor countries. Among policymakers, these rare events and other external shocks, such as terms-of-trade fluctuations and changes in international conditions, are often explicitly or implicitly blamed for the bad performance of growth. Do these rare events affect economic growth? Are the frequency and intensity of these rare events helpful in explaining the gap in income between rich and poor countries? The answer to this question is important not only for evaluating policies aimed at preventing these events and mitigating their consequences, but also for understanding the reasons why some countries are rich and some poor.

Although there has been a steady increase in the number of researchers tackling these questions, the effects of rare events on economic development and long-run growth remain unclear. There are some studies reporting negative effects while others report no effect or even positive effects. The purpose of this dissertation is to show that these seemingly contradictory findings can be reconciled by exploring the effects of disasters on growth separately by type of disaster. This study examines
the long- term economic impact of natural disasters and epidemics and shows that different types of rare events (natural disasters and epidemics) appear to be associated with different patterns of economic vulnerability ad so entail different options for reducing risk.

A few main conclusions emerge. Rare events significantly affect economic development but not always negatively, and differently across types of disasters and economic sectors. Hence, in order to understand and assess the economic consequences of natural disasters and epidemics and the implications for policy, it is necessary to consider the pathways through which different types of events affect economic development, the different risks posed, and the ways in which economies can respond to these threats.

Conceptual Framework

This section lays out the conceptual framework used to interpret our empirical findings in the following sections. The presentation is divided in two. First, I discuss how to think about the different implications natural disasters may have for economic development. Second, I present a simple two sector model of growth than captures a few of the most important channels through which natural disasters affect growth. From a theoretical point of view there are various models that could rationalize how different shocks (natural disasters) affect economic growth in the medium to longrun. Some natural disasters undoubtedly have a negative short term impact on GDP, and many do affect growth negatively in the medium to long term. For example, droughts can cause heavy crop and livestock losses over wide areas, often affecting several countries simultaneously, as happened in southern Africa in the early 1990s.

Extreme droughts may persist, lasting a few years. Such events have implications not only for agriculture but also for other water related, hydrologically sensitive sectors of an economy, such as hydroelectricity and domestic water supply Disasters may also affect long-run growth through increased indebtedness. Larger fiscal deficits, generated by the need to respond to natural disasters, have potential longterm development implications, primarily relating to the opportunity cost of future debtservicing and repayment costs. Disasters can exacerbate external debt pressures to the extent that they destroy infrastructure and other assets funded with outstanding external loans. Benson and Clay (1998) show that droughts generate big fiscal inbalances. Five of the six economies analized in their paper showed a sharp increase in government borrowing in response to drought

Author: Eduardo Augusto Olaberría, Doctor of Philosophy, 2010,Department of Economics, University of Maryland

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