Optimal Monetary Policy and Weather Shocks in Small Open Economies

Busato, Francesco and Cisco, Gianluigi and De Simone, Marco and Marzano, Elisabetta (2025): Optimal Monetary Policy and Weather Shocks in Small Open Economies.

Abstract

Climate change has led to an increase in extreme weather events, causing significant challenges for macroeconomic stability and monetary policy, particularly in small open economies (SOEs). This paper investigates the optimal monetary policy response to weather shocks in an SOE framework, using a Dynamic Stochastic General Equilibrium (DSGE) model calibrated for Turkey. The model includes sectoral price rigidities, trade openness, and climate-related productivity shocks affecting agricultural output. We evaluate alternative monetary policy rules, including those that target aggregate inflation, sector-specific inflation, and output stabilization. Our findings suggest that an aggressive monetary policy response to agricultural inflation mitigates short-term economic disruptions and accelerates recovery, albeit at the cost of a deeper initial contraction. The Ramsey-optimal policy prioritizes inflation stability while minimizing the long-term persistence of weather-induced output losses. Our results offer insights into the role of monetary policy in addressing climate-induced economic fluctuations in SOEs, highlighting the importance of tailored monetary policies that account for sectoral heterogeneities.

• Item Type: MPRA Paper
• Language: English
• Keywords: Agricultural output, Weather shocks, Dynamic Stochastic General Equilibrium Model
• Subjects: E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q5 - Environmental Economics > Q51 - Valuation of Environmental Effects; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q5 - Environmental Economics > Q54 - Climate ; Natural Disasters and Their Management ; Global Warming

References

[1] Acevedo, Sebastian, Mico Mrkaic, Natalija Novta, Evgenia Pugacheva, Petia Topalova et al. ”The effects of weather shocks on economic activity: what are the channels of impact?.” Journal of Macroeconomics 65 (2020): 103207.

[2] Adjemian, St´ephane, et al. ”Dynare: Reference manual, version 4.” (2011).

[3] Akta¸s, ¨Ozg¨ur. ”Impacts of climate change on water resources in Turkey.” Environmental Engineering Management Journal (EEMJ) 13.4 (2014).

[4] Angelopoulos, Konstantinos, George Economides, and Apostolis Philippopoulos. What is the best environmental policy? Taxes, permits and rules under economic and environmental uncertainty. No. 2980. CESifo Working Paper, 2010.

[5] Annicchiarico, Barbara, and Fabio Di Dio. ”GHG emissions control and monetary policy.” Environmental and Resource Economics 67 (2017): 823-851.

[6] Annicchiarico, Barbara, and Fabio Di Dio. ”Environmental policy and macroeconomic dynamics in a new Keynesian model.” Journal of Environmental Economics and Management 69 (2015): 1-21.

[7] Babao˘glu, Cenay, et al. ”T¨urkiye’s sustainable water policies and planning initiatives as part of climate change action.” Present Environment and Sustainable Development 17.1 (2023): 95-106.

[8] Batten, Sandra, Rhiannon Sowerbutts, and Misa Tanaka. ”Climate change: Macroeconomic impact and implications for monetary policy.” Ecological, societal, and technological risks and the financial sector (2020): 13-38.

[9] Bejarano, Jesùs, and Daniela Rodr´ıguez. ”The effects of climate change on a small and open economy: Economic and monetary perspectives.” Latin American Journal of Central Banking (2024): 100144.

[10] Boneva, Lena, Gianluigi Ferrucci, and Francesco Paolo Mongelli. ”Climate change and central banks: what role for monetary policy?.” Climate Policy 22.6 (2022): 770-787.

[11] Busato, Francesco, et al. ”E-DSGE Model with Environmentally Aware Consumers.” Italian Economic Journal (2024): 1-52.

[12] Cantelmo, Alessandro, Giovanni Melina, and Chris Papageorgiou. ”Macroeconomic outcomes in disaster-prone countries.” Journal of Development Economics 161 (2023): 103037.

[13] Economides, George, and Anastasios Xepapadeas. Monetary policy under climate change. No. 7021. CESifo Working Paper, 2018.

[14] Economides, George, and Anastasio Xepapadeas. The effects of climate change on a small open economy. No. 7582. CESifo Working Paper, 2019.

[15] Faccia, Donata, Miles Parker, and Livio Stracca. ”Feeling the heat: extreme temperatures and price stability.” (2021).

[16] Fischer, Carolyn, and Michael Springborn. ”Emissions targets and the real business cycle: Intensity targets versus caps or taxes.” Journal of Environmental Economics and Management 62.3 (2011): 352-366.

[17] Gallic, Ewen, and Gauthier Vermandel. ”Weather shocks.” European Economic Review 124 (2020): 103409.

[18] Garcìa-Verdù, Santiago, Manuel Ramos-Francia, and Manuel S´anchez-Mart´ınez. ”TIIE- 28 swaps as risk-adjusted forecasts of monetary policy in Mexico.” Quarterly Journal of Finance 9.02 (2019): 1950004.

[19] Guerròn-Quintana, Pablo A., and James M. Nason. 21 Bayesian estimation of DSGE models. Edward Elgar Publishing, 2013.

[20] Hargreaves, Andy. ”Development and desire: A postmodern perspective.” (1994).

[21] Heutel, Garth. ”How should environmental policy respond to business cycles? Optimal policy under persistent productivity shocks.” Review of Economic Dynamics 15.2 (2012): 244-264.

[22] Hernandez, E. Annette, and Venkatesh Uddameri. ”Standardized precipitation evaporation index (SPEI)-based drought assessment in semi-arid south Texas.” Environmental Earth Sciences 71 (2014): 2491-2501.

[23] Keen, Benjamin D., and Michael R. Pakko. ”Monetary policy and natural disasters in a DSGE model.” Southern Economic Journal 77.4 (2011): 973-990.

[24] Lucidi, Francesco Simone, Marta Maria Pisa, and Massimiliano Tancioni. ”The effects of temperature shocks on energy prices and inflation in the euro area.” European Economic Review 166 (2024): 104771.

[25] Natoli, Tommaso. ”Improving Coherence between Climate Change Adaptation and Disaster Risk Reduction through Formal and Informal International Lawmaking.” Journal of International Humanitarian Legal Studies 13.1 (2022): 78-109.

[26] Rotemberg, Julio J. ”Sticky prices in the United States.” Journal of political economy 90.6 (1982): 1187-1211.

[27] Smets, Frank, and Rafael Wouters. ”Shocks and frictions in US business cycles: A Bayesian DSGE approach.” American economic review 97.3 (2007): 586 606.

[28] Středová, H., Chuchma, F., & Středa, T. (2011). Climatic factors of soil estimated system. Bioclimate: Source and limit of social development, 137-138.

[29] Vicente-Serrano, Sergio M., et al. ”A new global 0.5 gridded dataset (1901–2006) of a multiscalar drought index: comparison with current drought index datasets based on the Palmer Drought Severity Index.” Journal of Hydrometeorology 11.4 (2010): 1033-1043.

[30] Vicente-Serrano, Sergio M., et al. ”Performance of drought indices for ecological, agricultural, and hydrological applications.” Earth Interactions 16.10 (2012): 1-27.

[31] Vicente-Serrano, Sergio M., et al. ”Response of vegetation to drought time-scales across global land biomes.” Proceedings of the National Academy of Sciences 110.1 (2013): 52-57.