Climate disasters force monetary policy trade-offs in Canada
A Bank of Canada working paper examines how natural disasters act as supply shocks, forcing central banks to balance output and inflation stabilization. Using a dynamic stochastic general equilibrium model, the authors evaluate historical Canadian events and future climate risks.
Simulating Canada's climate shock exposure
Researchers at the Bank of Canada use an open-economy dynamic stochastic general equilibrium model calibrated to Canada to evaluate the macroeconomic impact of natural disasters.
Embedding disaster shocks affecting capital, productivity, and the commodity sector, the authors show that most extreme weather events act as supply shocks.
These shocks simultaneously reduce economic output and modestly raise inflation, creating difficult policy dilemmas.
Historical events like the 1998 ice storm and prolonged droughts inflicted severe output losses, while external events like US hurricanes generated net expansionary effects through terms-of-trade improvements in global energy markets.
Navigating the output-inflation dilemma
The study evaluates monetary policy trade-offs by simulating alternative rules that span strict inflation versus output stabilization.
Costliest disasters, such as the 1998 ice storm, force central banks to choose between stabilizing output or containing inflation.
If policymakers had focused on closing the output gap after the ice storm, inflation would have been 0.15 percentage points higher.
Conversely, targeting inflation caused a mild drag on output.
As climate disasters increase in frequency and severity, these trade-offs are projected to worsen substantially for resource-rich economies.
A sobering look at climate realities
The paper delivers a vital framework for quantifying physical climate risks that resource-dependent central banks must confront.
By embedding commodity sector shocks, the model bridges a critical gap in macroeconomic forecasting.
Ultimately, policymakers face structural challenges that standard rate adjustments cannot fully mitigate.