Is monetary policy an efficient climate tool?
In this paper, Nakov and Thomas analyze the dynamics of a central bank which considers climate externalities as part of its decision-making process. Their model incorporates climate damages, green and fossil energy sectors, and carbon emissions into a standard New Keynesian framework. Key parameters are calibrated to values from the literature. They identify two scenarios for climate-conscious monetary policy:
- Carbon taxes follow the socially optimal path from the start: in this case, strict inflation targeting allows the central bank to replicate the socially efficient equilibrium, including the optimal path of CO2 emissions. Yet, this scenario is rather unrealistic.
- Carbon taxes start below the optimal level: in this case, a tension arises between price stability and climate goals which is resolved in favor of price stability. More specifically, suboptimal carbon taxes, during the transition, lead to excessive fossil energy consumption which the central bank might want to depress. Such climate-conscious monetary policy will result in output that is below its natural level forcing the central bank to accept temporarily lower inflation. An alternative policy, for this scenario, could be for central banks to tilt their corporate bond portfolios toward green bonds and away from brown bonds, compensating thus for the shortfall in carbon taxation. But green tilting, although it has the potential to accelerate the transition, its impact on atmospheric carbon concentration and global temperatures is small as it is limited by the eligibility criteria of central bank purchase programs.
In conclusion, while monetary policy can play a role in addressing climate change, its ability to do so is limited due to the untargeted nature of conventional instruments and design restrictions on unconventional tools. The paper emphasizes the importance of optimal carbon taxation and the challenges of integrating climate goals into monetary policy.
Climate-conscious monetary policy
Authors: Anton Nakov, Carlos Thomas
From: ECB, Banco de España
The importance of sequencing policies
In this paper, Steven Fries assesses the macroeconomic impacts of decarbonization and explains the observed policy sequencing patterns within sectors and countries as well as across them. Fries uses a model that has two key features: 1) A production function with variable elasticity of substitution (VES) between fossil fuel and low carbon inputs. This allows substitutability to increase with decarbonization progress. 2) A choice between two policies – carbon tax or low carbon subsidy. His main thesis is:
There is a tradeoff between decarbonizing productive activities and maintaining output, especially in countries creating initial markets for low-carbon technologies. The tradeoff depends on the substitutability of inputs.
This implies that:
- At early stages, the low carbon subsidy is of smaller scale than a comparable carbon tax. But their relative scale reverses with decarbonization progress.
- Sequencing explanation: Start with subsidy in sectors where low carbon inputs are stronger substitutes. This eases the output loss. Targeting sectors postpones larger losses in harder-to-decarbonize sectors.
- Long-run climate goals can shift expectations and induce innovation without concurrent carbon pricing/subsidies. Subsidies can also be more effective than carbon pricing in inducing innovation and mitigating output losses.
Sequencing decarbonization policies to manage their macroeconomic impacts
Author: Steven Fries
From: Peterson Institute for International Economics
