From financial instability to green finance: the role of banking and monetary policies in the Eurace model

We investigate appropriate banking and monetary policies aimed to pressure the banking and financial sector to shift from speculative lending, cause of asset bubbles and economic crises, to green investments lending, in order to foster the transition to a more energy efficient production technology. For this purpose, we consider an enriched Eurace model, which include new features such as a residential housing market, mortgage lending and heterogenous capital goods allowing for different degrees of energy efficiency in the production technology. Credit money in Eurace is endogenous and limited by Basel capital adequacy regulation on the supply side, while on the demand side it is determined by firms’ investments and households’ house purchasing. We introduce a differentiation of capital requirements according to the destination of lending, demanding higher banks’ capital in the case of speculative lending, thus encouraging banks to finance firms investments. As up-to-date capital goods have better energy efficiency in the model design, a higher pace of investments implies also a positive environmental effect. Results suggest that the proposed regulation is able to foster investments and capital accumulation in the short term, improving the energy efficiency of firms. However, reducing mortgages with a restrictive regulation has a negative impact on total private credit, and thus on endogenous money supply, weakening consumption and aggregated demand. In the long term, the contraction of total credit becomes stronger, and the negative outcomes on aggregated demand also affect investments. Therefore, in the long run, the positive effects on capital and energy efficiency become negligible, while the main economic indicators deteriorate.