Jeroen Klomp: Shaken Monetary Policy

This study explores whether earthquakes influence the policy interest rate set by the central bank. For this purpose a panel model for more than 85 countries is estimated thereby covering about 400 major earthquakes between 1960 and 2015.

Theoretically the impact is not a priori clear since earthquakes create a classic monetary policy dilemma: how to accommodate the real shock in the short-run with the objective of anchoring inflation when these two competing objectives demand opposite policy actions. The optimal interest rate response should therefore balance this trade-off.

The empirical findings point out that on average the short run policy interest rate drops in the first few months after the earthquake. This result indicates that the monetary authorities prioritize economic recovery above price stability. However, this interest rate effect is not uniform. It turns out that central banks which follow a specific monetary policy rule (i.e., fixed exchange rate) tend to raise the interest rate in the period following a disaster to fight the inflationary pressure. In turn, monetary authorities that have more discrete powers over the monetary policy are more flexible and lower the interest rate to stimulate economic recovery.