The Dynamic Effects of Environmental and Fiscal Policy Shocks

This paper studies the effects of aggregate shocks to government spending and to the available abatement technology in an economy with a polluting intermediate goods sector and nominal rigidities. The model implies that an abatement cost shock leads to a decline in both output and consumption regardless the type of climate regulation in place. Nonetheless, it turns out that these negative responses are attenuated when environmental policy revenues are used to diminish either consumption or labor income taxes instead of rebating them via lump-sum transfers. On the other hand, the positive effects of a government spending shock on output are maximized when both prices and wages are rigid, there is a carbon tax scheme instead of a cap-and-trade system, and the expansion in public expenditures is financed through lump-sum taxation.