Non-technical summary

Research Question

How do climate change and socially harmful emissions affect optimal monetary policy in the New Keynesian model? Since socially harmful emissions are strongly pro-cyclical, the output expansion during a boom is inefficiently large. Monetary policy can lean against such inefficient output expansions by cutting interest rates by less after a positive productivity shock. In this paper, we study how the monetary policy trade-off is resolved optimally in the presence of socially harmful emissions.

Contribution

We add pro-cyclical emissions to an otherwise standard New Keynesian business cycle model, which is typically used to study optimal monetary policy. Emissions represent a negative externality, as they increase costs associated with climate change. We focus on shocks to total factor productivity as drivers of business cycles. As customary in the literature, we approximate the competitive equilibrium and the optimal allocation up to second order around the deterministic steady state. This allows us to characterize the interplay between nominal rigidities and pro-cyclical emissions analytically in terms of a dynamic IS-equation and the New Keynesian Phillips curve.

Results

First, we show that, due to the emission externality, it is not optimal to close the difference between actual and potential output under flexible prices. Instead, the welfare-relevant output gap takes the economy’s overreaction to productivity shocks into account and includes an endogenous inflation-shifter term linked to the emission externality. This implies that optimal monetary policy does not perfectly stabilize prices and the natural output gap, even though it would be feasible to do so. Instead, the central bank cuts interest rates by less than in the counterfactual without pro-cyclical emissions, such that there is a smaller increase in actual output. The natural output gap is positive, and inflation deviates from zero. Optimal inflation volatility is an increasing function of the extent of the emission externality.