Severe weather shocks amplify US financial instability, impact investment

Severe weather shocks negatively impact US real and financial variables, particularly investment, but their effects are sizable only during periods of financial instability, such as the Great Recession.

In these times, banks' net worth drops and credit premiums increase.

The study finds only muted effects on nominal variables like inflation and and the federal funds rate, which monetary policy responds to with modest cuts.

Crucially, severe weather shocks are never a primary driver of business cycle fluctuations, explaining at best 3 percent of GDP growth variability.

The main transmission channel is through the deterioration in the quality of capital, where physical destruction impairs both goods-producing firms and bank assets, triggering a financial accelerator mechanism.

Temperature and sea level shocks are identified as the largest drivers of GDP contractions among individual weather events.

Interest in the links between severe weather, the economy, and financial stability has grown among policymakers and researchers.

However, a significant gap exists in formally integrating the financial system into these assessments.

This paper addresses this by developing a New Keynesian dynamic stochastic general equilibrium (NK DSGE) model that incorporates US banks and severe weather events.

The model explicitly accounts for a non-linear relationship, where the negative consequences of weather shocks are more pronounced when banks are already under stress, amplifying effects through a financial accelerator mechanism.

This structural approach provides a theory-based interpretation of transmission channels.