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Climate hysteresis and monetary policy

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  • Augustus J. Panton

Abstract

Since the birth of the natural rate hypothesis, the conventional notion that short-term output simply fluctuates around a relatively stable long-term trend became the norm in modern macroeconomics, including in the standard New Keynesian DSGE model. However, the global financial crisis (GFC) led to a serious rethinking of this norm, giving rise to the re-emergence of the Blanchard-Summers’ hysteresis debate and a new business cycle paradigm in which the short-term output effects of financial crises permanently feed into long-term growth trends. Using a Bayesian-estimated structural multivariate filtering model calibrated to data for Australia and the United States, the innovation of this paper is the incorporation of climate hysteresis into the estimation of potential output and the output and unemployment gaps. The results suggest non-trivia implications for monetary policy in a carbon-constrained world. Not only are the model-based estimates of potential output and NAIRU more volatile with climate shock persistence, the climate-neutral output and unemployment gap estimates are much smaller than conventional estimates, with different implications for inflation signals during the upturn or downturn of the business cycle. For economies that are more susceptible to disruptive climate shocks, especially in the developing world, an environment in which both demand conditions and the underlying supply potential are rapidly changing will severely complicate the conduct of forward-looking macroeconomic policy.

Suggested Citation

  • Augustus J. Panton, 2020. "Climate hysteresis and monetary policy," CAMA Working Papers 2020-76, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  • Handle: RePEc:een:camaaa:2020-76
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    More about this item

    Keywords

    Potential output; output gaps; NAIRU; physical climate risks;
    All these keywords.

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • Q51 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Valuation of Environmental Effects

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