Dynamic Stochastic Macroeconomic Model of Disaster Risk Reduction Investment in Developing Countries

Abstract

This research formulates a dynamic stochastic macroeconomic model that includes an optimization problem for the formation of stock of human capital, production capital, and household assets, and quantitatively examines economic impacts of disaster on developing countries. We further investigate the optimal policy of development of disaster risk reduction (DRR) capital by considering costs of DRR investment, and show that the effect of DRR investment on economic growth is like a single-peaked curve with respect to the DRR investment rate, which implies that overaccumulation could decelerate economic growth. Moreover, this study emphasizes an effect that DRR capital increases the shadow values of other types of capital and assets by reducing risks of destruction. Importantly, this effect emerges even in cases of process, in which disaster does not actually occur for a long period. We decompose the effects of DRR investments into two parts: "ex-ante risk reduction effect" (ARRE) and "ex-post damage mitigation effect" (PDME). Furthermore, we develop a method of measuring ARRE and PDME by applying the results of Monte Carlo simulation, and show that the scale of ARRE is nonnegligible using a case study of Pakistan. The results imply that types of models that cannot valuate ARRE underestimate the value of DRR investment.

Keywords: Disaster risk reduction investment; Monte Carlo simulation; dynamic stochastic macroeconomic model; economic growth; ex-ante risk reduction effect.