Temperature Shocks and Welfare Costs

Abstract

This paper examines the welfare implications of rising temperatures. Using a standard VAR, we empirically show that a temperature shock has a sizable, negative and statistically significant impact on TFP, output, and labor productivity. We rationalize these findings within a production economy featuring long-run temperature risk. In the model, macro-aggregates drop in response to a temperature shock, consistent with the novel evidence in the data. Such adverse effects are long-lasting. Over a 50-year horizon, a one-standard deviation temperature shock lowers both cumulative output and labor productivity growth by 1.4 percentage points. Based on the model, we also show that temperature risk is associated with non-negligible welfare costs which amount to 18.4% of the agent's lifetime utility and grow exponentially with the size of the impact of temperature on TFP. Finally, we show that faster adaptation to temperature shocks results in lower welfare costs. These welfare benefits become substantially higher in the presence of permanent improvements in the speed of adaptation.JEL classification: E30, G12, Q0

Macroeconomic Outcomes in Disaster-Prone Countries

“…by setting the probability of rare disasters equal to zero. 24 Similarly, Donadelli et al (2017) compute the loss in the optimal consumption path that agents are willing to suffer to completely eliminate long-term temperature risk. 25 Given that our two representative countries differ only by the distributions of natural disaster shocks, our approach enables us to quantify how natural disasters (and in some 24 While in Barro (2009) rare disasters do not include natural events, Barro (2015) extends the former model to include the probability of environmental disasters.…”

“…30 In particular, Barro (2009) calculates welfare losses of about 8-9% arising from the risk of rare disasters (not necessarily natural disasters). Similarly, Donadelli et al (2017) report welfare losses of 4.6% and 9.2% due to the long-run temperature risk, depending on the elasticity of productivity to temperature shocks. 31 Our welfare loss, despite being of the same order of magnitude, is lower because we calculate it relative to a calibration with less frequent and less damaging natural disasters.…”

“…31 Our welfare loss, despite being of the same order of magnitude, is lower because we calculate it relative to a calibration with less frequent and less damaging natural disasters. Conversely, both Barro (2009) andDonadelli et al (2017) compute the welfare losses relative to a scenario where rare disasters and temperature shocks are completely eliminated. Moreover, relative to Barro (2009), in line with our stylized facts, we assume a larger disaster probability (16.2% vs 1.7%) but our average damage is almost 4 times smaller (6.65% vs 26% of GDP).…”

“…The remainder is explained by the presence of large shocks and nonlinearities. 31 Both Barro (2009) andDonadelli et al (2017) calibrate their models at an annual frequency, while we study a quarterly model. For the purpose of comparison, we have converted their welfare losses from annual to quarterly.…”

Global Temperature, R&D Expenditure, and Growth

“…Specifically, the model captures the long-lasting effect that global temperature has on world consumption growth observed in the data. Based on the empirical evidence that temperature shocks undermine TFP growth, Donadelli, Jüppner, Riedel, and Schlag (2017), following the approach of Bansal and Ochoa (2011b), integrate U.S. temperature dynamics into a production-based model featuring recursive preferences, long-run productivity risk, and investment adjustment costs. We differ from these theoretical approaches aiming at studying the macroeconomic effects of climate change-related phenomena in that we analyze the welfare implications of rising temperatures within a stochastic endogenous growth framework.…”