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The Price vs Quantity Debate: Climate policy and the role of business cycles

  • Anna Grodecka
  • Karlygash Kuralbayeva

What is the optimal instrument design and choice for a regulator attempting to control emissions by private agents in face of uncertainty arising from business cycles? In applying Weitzman's result [Prices vs. quantities, Review of Economic Studies, 41 (1974), 477-491] to the problem of greenhouse gas emissions, the price-quantity literature has shown that, under uncertainty about abatement costs, price instruments (carbon taxes) are preferred to quantity restrictions (caps on emission), since the damages from climate change are relatively fl at. On the other hand, another recent piece of academic literature has highlighted the importance of adjusting carbon taxes to business cycle fl uctuations in a procyclical manner. In this paper, we analyze the optimal design and the relative performance of price versus quantity instruments in the face of uncertainty stemming from business cycles. Our theoretical framework is a general equilibrium real business cycle model with a climate change externality and distortionary fiscal policy. First, we find that in an infinitely exible control environment, the carbon tax fl uctuates very little and is approximately constant, whilst emissions fl uctuate a great deal in response to a productivity shock. Second, we find that a fixed price instrument is advantageous over a fixed quantity instrument due to the cyclical behavior of abatement costs, which tend to increase during expansions and decline during economic downturns. Our results suggest that the carbon tax is approximately constant over business cycles due to "flat" damages in the short-run and thus procyclical behavior as suggested by other studies cannot be justified merely on the grounds of targeting the climate externality.

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Paper provided by Oxford Centre for the Analysis of Resource Rich Economies, University of Oxford in its series OxCarre Working Papers with number 137.

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Date of creation: 2014
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Handle: RePEc:oxf:oxcrwp:137
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  13. Rezai, Armon & van der Ploeg, Frederick, 2014. "Intergenerational inequality aversion, growth and the role of damages: Occam’s rule for the global carbon tax," CEPR Discussion Papers 10292, C.E.P.R. Discussion Papers.
  14. Kuralbayeva, Karlygash, 2013. "Optimal fiscal policy and different degrees of access to international capital markets," Journal of Development Economics, Elsevier, vol. 103(C), pages 336-352.
  15. Zhu, Xiaodong, 1992. "Optimal fiscal policy in a stochastic growth model," Journal of Economic Theory, Elsevier, vol. 58(2), pages 250-289, December.
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