Dynamic response of the natural interest rate to extreme climate

The natural interest rate serves as a critical benchmark for central banks in formulating monetary policy and assessing macroeconomic equilibrium. Despite increasing concerns regarding climate change, the macroeconomic implications of extreme climate risks—particularly their transmission channels—remain insufficiently explored. This paper firstly integrates extreme climate risks into a dynamic growth model to analyze their impact on the natural interest rate theoretically. Then employing global panel data from 1980 to 2022 and utilizing the Cross-Sectionally Augmented Autoregressive Distributed Lag (CS-ARDL) approach, it demonstrates that extreme climate risks have no significant effect on the natural interest rate in the short term, while significantly depresses the natural interest rate in the long term. And this long-term reduction is particularly pronounced in lower and middle-income countries, those experiencing rapid warming, and nations with stringent inflation targeting regimes. Furthermore, the findings indicate that extreme climate risks depress the natural interest rate by augmenting savings and diminishing total factor productivity in the long run. Conversely, in the short term, these risks lead to increased government spending, which temporarily raises the natural interest rate; nonetheless, this short-term effect diminishes when considering long-term impacts. Moreover, the development of green finance plays a pivotal role in alleviating the long-term suppression of the natural interest rate due to extreme climate risks. By establishing climate risks as fundamental determinants of the natural interest rate, this research provides theoretical foundations for central banks to recalibrate policy frameworks, offering actionable insights for the integration of climate resilience into monetary policy design.