Navigating Turbulence: Policy Coordination under Natural Disaster Risk in Developing Countries

This paper examines the complex trade-off between inflation stabilization, debt sustainability, and economic recovery resulting from natural disasters in developing economies. I develop a small open economy New Keynesian DSGE model in which disaster shocks destroy productive capital, reduce productivity and generate substantial reconstruction needs and fiscal pressures. The model examines how these shocks are transmitted under monetary and fiscal dominance. Results show that natural disasters increase public debt, weaken fiscal policy's ability to stabilize the economy, and constrain monetary policy. Under monetary dominance, the central bank preserves price stability more effectively, but this requires stronger fiscal adjustments and results in a deeper contraction in economic activity. Under fiscal dominance, monetary policy accommodates the deterioration of public finances: inflation rises, reducing the real value of government liabilities and facilitating fiscal adjustment. Welfare analysis indicates that partial monetary accommodation may be desirable in disaster-prone economies because it reduces output volatility and eases the real value of public debt, albeit at the cost of higher inflation post-disaster.