Climate change and economic prosperity: Evidence from a flexible damage function

The climate damage function used to assess the economic impact of secular changes in temperature and precipitation is one of the most speculative components of integrated assessment models of climate change. Whether detrimental effects of temperature change on economic prosperity are most significant for countries with low incomes or those with high temperatures is still an unresolved question in the literature, while changes in precipitation are widely regarded as not having any significant productivity effects. Existing work informing this debate is based on pooled empirical models incorporating simple interaction terms with ‘low income’ or ‘high temperature’, which further give little regard to long-term dynamics. We use aggregate and agricultural data for 154 countries over the past six decades to estimate dynamic heterogeneous models which (a) allow the weather-output nexus to differ freely across countries, (b) help distinguish short-run from long-run effects, and (c) account for unobserved time-varying heterogeneity. Our preferred specifications suggest that a temporary (permanent) 1?C rise in temperature is associated with a reduction in income per capita of 1.3% (14%) in high-temperature countries, with the long-run effects substantially larger than those commonly suggested in the literature. We find weaker differential effects by income-group. We further highlight that changes in precipitation levels can influence short-run and long-run agricultural output per worker in high-temperature or low-income countries, albeit to a very modest extent.