Occasionally binding emission caps and real business cycles

Recent applications to the modeling of emission permit markets by means of stochastic dynamic general equilibrium models look into the relative merits of different policy mechanisms under uncertainty. The approach taken in these studies is to assume the existence of an emission constraints that is always binding (i.e. the emission cap is always smaller than what actual emissions would be in the absence of climate policy). Although this might seem a reasonable assumption in the longer term, as policies will be increasingly stringent, in the short run there might be instances where this assumption is in sharp contrast with reality. A notable example would be the current status of the European Emission Trading Scheme. This paper explores the implications of adopting a technique that allows occasionally, rather than strictly, binding constraints. With this new setup the paper sets out to investigate the relative merits of different climate policy instruments under different macro-economic shocks. Keywords: Dynamic Stochastic General Equilibrium model, emission trading, carbon tax, occasionally binding constraints. JEL codes: Q58, Q54, E2.