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Description:
This paper develops a simple New Keynesian model incorporating a small time-varying probability that the economy is struck by a disaster in the future. The model's main prediction is that a small increase in the disaster probability causes a recession in the economy, speci cally due to limited saving opportunities inasmuch as the model abstracts from capital accumulation. By contrasting its ndings to the ones of a comparable real business cycle model, this paper evaluates how the disaster hypothesis has been used and modelled in the existing literature.