Optimal Climate and Monetary-Fiscal Policy in a Climate-DSGE Framework

This paper points to the welfare enhancing effect of policies to regulate emissions in the face of climate shock. Fiscal and monetary policies alone would achieve suboptimal outcomes. We consider the Ramsey-optimal long-run and dynamic policy interactions between climate and fiscal-monetary policies in a climate-monetary DSGE model under sticky prices. In the model, the planner – on top of a fiscal and a monetary instrument – controls also a carbon tax (or, equivalently, an emission abatement technology) to manage emissions, and therefore temperatures and climate damages. In this setup, the presence of carbon taxation sharply reduces the fall in key macroeconomic variables such as output, consumption, and welfare, to a shock to emissions compared with the case without carbon taxation in place. We also show that it is essential to consider climate-specific shocks to appreciate the importance of carbon policies; the Ramsey optimal solution to typical TFP or government spending shocks is not very different whether or not the planner has access to carbon taxation. In the face of climate shocks, the optimal monetary is very similar to the one under no climate policy, while the optimal fiscal policy set distortionary labor income taxation at a lower rate, as the planner now raises revenue also through carbon taxes. Finally, in an extension of the model, we show that the optimal environmental implications can significantly change as we explicitly include climate fiscal outlays in the government budget constraint. As climate change becomes more costly for the government, the optimal abatement increases and the magnitude of carbon emissions and thus output damages decreases.