Optimal monetary policy in a two-sector environmental DSGE model

Oliver Holtemöller and Alessandro Sardone ()

No 18/2024, IWH Discussion Papers from Halle Institute for Economic Research (IWH)

Abstract: In this paper, we discuss how environmental damage and emission reduction policies affect the conduct of monetary policy in a two-sector (clean and dirty) dynamic stochastic general equilibrium model. In particular, we examine the optimal response of the interest rate to changes in sectoral inflation due to standard supply shocks, conditional on a given environmental policy. We then compare the performance of a nonstandard monetary rule with sectoral inflation targets to that of a standard Taylor rule. Our main results are as follows: first, the optimal monetary policy is affected by the existence of environmental policy (carbon taxation), as this introduces a distortion in the relative price level between the clean and dirty sectors. Second, compared with a standard Taylor rule targeting aggregate inflation, a monetary policy rule with asymmetric responses to sector-specific inflation allows for reduced volatility in the inflation gap, output gap, and emissions. Third, a nonstandard monetary policy rule allows for a higher level of welfare, so the two goals of welfare maximization and emission minimization can be aligned.

Keywords: climate change; environmental policy; inflation; macroeconomic stabilization; monetary policy (search for similar items in EconPapers)
JEL-codes: E32 E52 E58 Q54 Q58 (search for similar items in EconPapers)
Date: 2024
New Economics Papers: this item is included in nep-cba, nep-dge, nep-ene and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:iwhdps:301153

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