Economic impact of hurricane Katrina

Hurricane Katrina may sting U.S. economic growth by choking energy supplies even as the damages caused by the storm spur massive rebuilding and emergency government spending.

Economists, while emphasizing that few concrete damage assessments have yet been made, said the major hurricane that struck the country's key Louisiana energy gateway would help sustain high oil, gasoline and natural gas prices.

A seasonal downturn in demand expected after next weekend and a higher-than-usual build-up in inventories ahead of the North American winter had led to forecasts energy prices might ease in coming months.

Some economists said U.S. gross domestic growth had been already showing signs of easing and may now slow more rapidly if fallout from Katrina boosts oil to $100 a barrel for a month, or U.S. gasoline prices to $3.50 a gallon, for a few months.

"The impact on the consumer spending in such a scenario would be very dramatic, cutting the growth rate by as much as 3 percent and push real GDP growth in the fourth quarter closer to zero," Global Insight said in a preliminary analysis.

The Lexington, Massachusetts, economics consultancy said that, if oil stayed at the current $65 to $70 level for a couple of more months because of energy flow disruptions, GDP growth would be cut 0.3 percent to 0.5 percent in the fourth quarter.

On Monday, at least two oil rigs were adrift in the Gulf of Mexico, where Katrina raged through offshore fields. Fearing the worst, oil companies had shut rigs and closed refineries along the coast. U.S. oil futures jumped nearly $5 a barrel in opening trade to touch a peak of $70.80 before settling back.

"It looks like the potential disruption has helped to further boost gasoline prices and that could be some additional headwind for the economy," said senior economist Patrick Fearon at A.G. Edwards & Sons Inc. in St. Louis.

Fearon said A.G. Edwards may later this week trim its forecast of a 4 percent annualized GDP rise in the third quarter.

The Economic Outlook Group in Princeton Junction, New Jersey, said Katrina's effect on energy prices would add to risks facing the U.S. economy and could prompt the Federal Reserve to skip a widely expected interest rate hike when it meets Sept 20.

"This is not to say they will not resume raising rates in November and December. It's just that Fed officials may want to evaluate the extent of Katrina's impact on business activity, consumer demand and on inflation pressures," Economic Outlook said.

Katrina, which last week hit south Florida, was expected to cause a total of $10 billion to $26 billion in insured damages, according to hurricane modeling firms. It could be the most expensive storm to ever hit the United States.

"There will be a lot of rebuilding that is going to need to occur. These things do spur GDP growth," said Ken Mayland, president of ClearView Economics in Pepper Pike, Ohio.

Diane Swonk, chief economist at Mesirow Financial in Chicago, said wages lost by workers and revenues missed at shops and other businesses would be generally short-lived and replaced by stepped-up demand for construction and other workers and higher sales at home-supplies outlets.

The storm may also have damaged the Port of Southern Louisiana, the world's fifth largest port by tonnage and the biggest in the United States, and may affect exports and imports of agricultural and other products, according to Swonk.

"Depending on the extent of damage, that will put pressure on other ports. A drought in the Midwest has slowed some barges and there could be some transitory impact on our GDP," Swonk said.

Freight railroads might pick up some of that transport business if the port is hobbled, she said.

Travel, leisure and gambling businesses in Louisiana, Mississippi and Alabama may lose some tourist visits to other U.S. destinations, such as Las Vegas and Florida, during the cleanup and rebuilding ahead, she said.

1. According to Global Insight, a Massachusetts economics consultancy, what will happen if oil prices remain in the range of $65 to $70 per barrel for a couple of more months.
A. U.S. GDP growth will drop 0.3% to 0.5% in the fourth quarter of 2005.

B. The Fed will almost certainly cut interest rates the next time it meets.

C. Gasoline prices could reach $4.75 per gallon.

D. U.S. GDP growth will drop by 7% in the fourth quarter of 2005.

2. The Federal Reserve (or "the Fed" for short) conducts monetary policy in the United States. That is, the Fed decides how much money to supply to the economy. When the Fed increases the money supply, money becomes more abundant and the costs of borrowing money (that is, interest rates) fall. When the Fed reduces the money supply, money becomes scarce and interest rates rise.

According to the Economic Outlook Group, an economic consultancy in New Jersey, higher energy prices resulting from Katrina may lead the Fed to __________ next time it meets.

A. Lower interest rates

B. Skip an expected interest rate hike

C. Raise interest rates

D. Skip an expected interest rate cut

We can analyze the macroeconomic effects of Hurricane Katrina using the aggregate supply (AS) and aggregate demand (AD) diagram. The horizontal axis measures real GDP, a measure of the nation's output that removes the effects of inflation. The vertical axis measures the price level, or the average level of output prices.

3.1. Consider Katrina's effect on aggregate supply (AS).

Cost shocks -- unexpected changes in the prices of important inputs -- shift the aggregate supply curve. For example, Katrina unexpectedly choked off oil, natural gas, and refined gasoline supplies from the Gulf region, placing upward pressure on energy costs. The hurricane also shut down factories and businesses, reducing the nation's productive capacity. What is the effect of the higher energy prices and reduced productive capacity on aggregate supply by shifting the AS curve and/or aggregate demand which direction.

3.2. Consider how the government's fiscal policy response affects aggregate demand (AD).

The AD curve shows how many final goods and services are bought as a function of the average price level. Both individual consumers' purchases and government purchases are included in aggregate demand.

The federal government is now devoting a massive amount of spending to aid and reconstruction. Some of this aid takes the form of direct government purchases of goods and services, like the fees paid to transportation companies and hospitals to take care of victims. Some of the aid, like the $2,000 debit cards given to some displaced families, takes the form of direct transfers to citizens. What are the effect of the increase in government spending on the AD curve.

3.3. You've considered two different economic shocks resulting from Katrina:

1) An aggregate supply shock: Katrina increased energy prices and temporarily reduced U.S. productive capacity.
2) An aggregate demand shock: Government responded to the hurricane with massive expenditures on aid and rebuilding.

What does the aggregate supply and aggregate demand model predict about the combined impact of these shocks on the U.S. economy?

A. Real GDP may rise or fall, but the price level will definitely rise.

B. Real GDP will definitely rise, but the price level may rise or fall.

C. Real GDP will definitely fall, but the price level will definitely rise.

D. Real GDP may rise or fall, but the price level will definitely fall.

Solution Summary

Effects of hurricane Katrina in terms of GDP and aggregate demand