What is the likelihood that the U.S. will experience a devastating catastrophic event over the next few decades that would substantially reduce the capital stock, GDP and wealth? Can the probability and possible impact of such an event be inferred from economic data? And how much should society be willing to pay to reduce the probability or impact of a catastrophe? We address these questions using a general equilibrium model that describes production, capital accumulation, and household preferences, and includes the possible arrival of catastrophic shocks. Calibrating to economic and financial data shows the annual mean arrival rate of shocks to be about 1.5% and the expected loss from a shock to be about 30%. We use the model to calculate the tax on consumption society would accept to reduce the probability of a shock, and the cost to insure against its actual impact.
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This paper was revised on December 5, 2011
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