Francesca Diluiso, Boromeus Wanengkirtyo and Jenny Chan.
This post examines key aspects of climate mitigation policies that could matter for monetary policy, using insights from structural climate macroeconomic models (Environmental Dynamic Stochastic General Equilibrium). Three main findings emerge: first, mitigation policies – like carbon pricing – can be a direct source of shocks, creating potential trade-offs for monetary policy (Carney (2017)). Second, the degree to which these policies are anticipated affects their macroeconomic impacts. Third, different climate policies may alter the transmission of conventional business-cycle socks, therefore affecting the calibration of optimal monetary policy. We focus on the 3–5 year horizon, abstracting from longer-run considerations and changing trends such as interactions with the zero lower bound, the natural interest rate, or transitional effects on productivity and output.
Climate change mitigation policies can be a direct source of shocks
To achieve the proposed climate targets, orderly transitions scenarios feature a steady increase in the price of carbon along a transition path (NGFS (2023)). This upward trend of carbon prices alone may have substantial macroeconomic effects, but even along the transition path, actual carbon prices can fluctuate around this trend. The prices in traded carbon markets (such as the UK and EU Emissions Trading System (ETS)) – where firms in particular sectors must pay for allowances to emit carbon or its equivalents – have historically done so.
Previous empirical analysis, such as in Mann (2023) for the UK and Känzig (2023) for the euro area, have shown that increases in the EU ETS prices can lead to higher inflation rates. We find similar results in our E-DSGE model calibrated for the UK economy: an increase in the price of carbon transmits as a cost-push shock, increasing inflation and decreasing GDP (Chart 1). We assume monetary policy follows a Taylor rule, responding to changes in inflation and the output gap. While sudden increases in carbon prices can create upward pressure on inflation and adversely affect output, a future one-sided sequence of shocks (a ‘carbon price ratchet’) could pose more challenges for policymakers along the transition path to a net zero consistent carbon price level.
Chart 1: Output and inflation response to a temporary and permanent (small) increase in the price of carbon
Notes: Time on the horizontal axis is in quarters. The increase in the carbon price in this exercise is only 1%. Historical fluctuations in UK/EU ETS have been much larger.
However, as the chart above suggests, the overall effect on inflation and output also depends on the nature of the carbon price increase (transitory versus permanent) and the capacity of economic agents to anticipate future economic effects of the policy. We explore this next.
The degree to which climate policy is anticipated affects the impact on inflation and output
When the increase in the carbon price is temporary (Chart 1, dashed line), and perceived as such by economic agents, the decrease in consumption and investment is short-lived and output recovers relatively quickly once inflationary pressures due to higher production costs dissipate.
On the contrary, when policy leads to a permanent (or gradual) increase in the carbon price (Chart 1, solid line), the fall in aggregate demand is larger and persistent. Households and firms take into account the increase in (future) policy stringency, which affects their permanent income. Therefore, they begin to adjust their consumption and investment plans to the new policy environment and corresponding economic conditions. In this case, the demand channel is sufficiently strong to partially overcome the supply-side effects of the shock: output falls by more, and inflation is correspondingly weaker, leading to a smaller monetary policy trade-off. This result is in line with studies suggesting the green transition can lead to mild inflationary pressures or can even be deflationary, based on agents’ expectations about future climate policy and consequent adjustments in aggregate demand.
The degree to which households and firms are forward-looking (and anticipate the future effects of policy) is crucial for understanding the magnitude of adjustment in output and inflation along the transition. Annicchiarico et al (2024) have shown that, when agents are not fully capable of understanding and anticipating the nature of the shock, the adjustment process is prolonged, with milder adverse effects on output but more persistent inflationary pressures. They also show that the magnitude of the impact can vary according to the type of carbon pricing policy implemented, with cap-and-trade schemes being more inflationary and carbon taxes weighing more on output.
Carbon pricing policies may alter the transmission of ‘conventional’ macroeconomic shocks
While the previous sections demonstrated the direct effects of carbon pricing policies on output and inflation, this section shows how different carbon pricing policies can interact with, and modify, the transmission of conventional macroeconomic shocks (see eg, Annicchiarico and Di Dio (2015) and Annicchiarico and Diluiso (2019)). This has potential implications for how monetary policy should be calibrated to optimally respond to economic fluctuations.
Chart 2 shows the reaction to a positive supply shock and a negative demand shock when the economy is subject to two different carbon pricing policies that have been identified by the literature as cost-effective instruments to reach climate targets: a cap-and-trade scheme and a carbon tax. While a carbon tax sets the price of carbon emissions and allows the market to determine the reduction in emissions, a cap-and-trade system sets the quantity of emissions allowed. These two policies imply a different behaviour for emissions, emission prices, and thus economic activity. Under a carbon tax the carbon price is fixed, while emissions move procyclically in response to other macroeconomic shocks. The opposite is true for a cap-and-trade.
Chart 2: Response to supply and demand shocks under different carbon pricing policies
Notes: The positive supply shock represents a 1% increase in total factor productivity, while the negative demand shock is a 50 basis points increase in the nominal interest rate. Time on the horizontal axis is in quarters.
Source: Authors’ simulations based on Annicchiarico and Diluiso (2019).
Under a carbon tax, a positive supply shock reduces marginal costs associated with capital and labour, leading to the same decrease in inflation and an increase in output we would experience in the absence of climate policy. While the increase in production leads to an increase in emissions, the carbon price stays the same, with no additional effect on marginal costs.
We find, instead, that in the short term, a cap-and-trade system behaves like an ‘automatic stabiliser’ for output and inflation in response to a supply shock (which moves output and inflation in the opposite direction). Firms’ marginal costs depend on the cost of production inputs (capital and labour), as well as the carbon price. In response to a positive supply shock, the marginal cost component dependent on labour and capital decreases. However, the carbon price rises because an increase in production increases firms’ demand for emissions permits. This raises marginal costs, dampening the effect of the initial shock on both output and inflation.
However, in response to a demand shock (which moves output and inflation in the same direction), a cap-and-trade scheme delivers lower output volatility but higher inflation volatility. Following a contractionary monetary policy shock (right panel in Chart 2), inflation decreases more under a cap-and-trade. This is because the labour, capital and carbon price components of marginal costs all decrease, increasing the negative response of inflation. The larger decline in marginal costs also helps to sustain aggregate demand. These results suggest that a cap-and-trade system can potentially improve the ‘sacrifice ratio’ for monetary policy (ie lowering inflation with a smaller output cost).
Conclusion
Monetary policy cannot solve climate change, but its macroeconomic implications are relevant for monetary policy. From extreme weather events to the greening of sectors, the effects on inflation and output should be monitored and understood since monetary policy may need to respond to meet its objectives. In the words of Catherine Mann, monetary policymakers should be ‘forward-looking, to monitor and make an informed decision about how all this affects inflation at [my] three-year policy horizon’. This post has highlighted some key aspects for understanding the economic impact of climate policy: mitigation policies can induce trade-offs, their effects depend on agents’ expectations and policy credibility, and different carbon pricing policies may alter the transmission of conventional shocks.
Francesca Diluiso and Boromeus Wanengkirtyo work in the Bank’s Structural Economics Division and Jenny Chan works in the Bank’s External MPC Unit.
If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.
Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.
Share the post “Some implications of climate policy for monetary policy”
