"Green" fiscal policy measures and non-standard monetary policy in the euro area

This paper evaluates the macroeconomic effects of increasing taxes on fossil fuels ("carbon tax") and subsidies for renewable energy and reducing labor income tax in the euro area, and the interaction of these effects with domestic monetary policy. The tax increase is announced, gradually implemented and fully anticipated by agents (thus it is conceptually different from a sudden and unexpected positive shock affecting the international prices of fossil fuels). The analysis makes use of a New Keynesian two-country model with an energy sector, calibrated to the euro area and the rest of the world. The main results are the following. First, an increase in the carbon tax generates recessionary effects. Second, higher subsidies for green energy and a lower labor tax can limit the macroeconomic cost of increasing the carbon tax. Third, if the monetary policy rate is at its effective lower bound, the fiscal policy mix generates short-run recessionary effects, which can be offset if the central bank, for monetary policy purposes, purchases long-term sovereign bonds in the secondary market, thus keeping long-term interest rates low.