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Welfare Costs of Long-Run Temperature Shifts

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  • Ravi Bansal
  • Marcelo Ochoa

Abstract

This article makes a contribution towards understanding the impact of temperature fluctuations on the economy and financial markets. We present a long-run risks model with temperature related natural disasters. The model simultaneously matches observed temperature and consumption growth dynamics, and key features of financial markets data. We use this model to evaluate the role of temperature in determining asset prices, and to compute utility-based welfare costs as well as dollar costs of insuring against temperature fluctuations. We find that the temperature related utility-costs are about 0.78% of consumption, and the total dollar costs of completely insuring against temperature variation are 2.46% of world GDP. If we allow for temperature-triggered natural disasters to impact growth, insuring against temperature variation raise to 5.47% of world GDP. We show that the same features, long-run risks and recursive-preferences, that account for the risk-free rate and the equity premium puzzles also imply that temperature-related economic costs are important. Our model implies that a rise in global temperature lowers equity valuations and raises risk premiums.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17574.

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Date of creation: Nov 2011
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Handle: RePEc:nbr:nberwo:17574

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  1. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08.
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  7. Ravi Bansal & Robert F. Dittmar & Christian T. Lundblad, 2005. "Consumption, Dividends, and the Cross Section of Equity Returns," Journal of Finance, American Finance Association, vol. 60(4), pages 1639-1672, 08.
  8. Hanno Lustig & Stijn Van Nieuwerburgh & Adrien Verdelhan, 2008. "The Wealth-Consumption Ratio," NBER Working Papers 13896, National Bureau of Economic Research, Inc.
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  13. Ravi Bansal & Marcelo Ochoa, 2011. "Temperature, Aggregate Risk, and Expected Returns," NBER Working Papers 17575, National Bureau of Economic Research, Inc.
  14. Tobias N. Rasmussen, 2004. "Macroeconomic Implications of Natural Disasters in the Caribbean," IMF Working Papers 04/224, International Monetary Fund.
  15. Ravi Bansal & A. Ronald Gallant & George Tauchen, 2007. "Rational Pessimism, Rational Exuberance, and Asset Pricing Models," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1005-1033.
  16. Monika Piazzesi & Martin Schneider, 2007. "Equilibrium Yield Curves," NBER Chapters, in: NBER Macroeconomics Annual 2006, Volume 21, pages 389-472 National Bureau of Economic Research, Inc.
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  19. Harjoat S. Bhamra & Lars-Alexander Kuehn & Ilya A. Strebulaev, 2010. "The Levered Equity Risk Premium and Credit Spreads: A Unified Framework," Review of Financial Studies, Society for Financial Studies, vol. 23(2), pages 645-703, February.
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Cited by:
  1. Robert S. Pindyck, 2012. "The Climate Policy Dilemma," NBER Working Papers 18205, National Bureau of Economic Research, Inc.
  2. Robert S. Pindyck, 2012. "Risk and Return in Environmental Economics," NBER Working Papers 18262, National Bureau of Economic Research, Inc.

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