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How Should Environmental Policy Respond to Business Cycles? Optimal Policy under Persistent Productivity Shocks

  • Heutel, Garth

    ()

    (University of North Carolina at Greensboro, Department of Economics)

How should environmental policy respond to economic fluctuations caused by persistent productivity shocks? This paper answers that question using a dynamic stochastic general equilibrium real business cycle model that includes a pollution externality. I first estimate the relationship between the cyclical components of carbon dioxide emissions and US GDP and find it to be inelastic. Using this result to calibrate the model, I find that optimal policy allows carbon emissions to be procyclical: increasing during expansions and decreasing during recessions. However, optimal policy dampens the procyclicality of emissions compared to the unregulated case. A price effect from costlier abatement during booms outweighs an income effect of greater demand for clean air. I also model a decentralized economy, where government chooses an emissions tax or quantity restriction and firms and consumers respond. The optimal emissions tax rate and the optimal emissions quota are both procyclical: during recessions, the tax rate and the emissions quota both decrease.

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Paper provided by University of North Carolina at Greensboro, Department of Economics in its series Working Papers with number 11-8.

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Length: 58 pages
Date of creation: 08 Mar 2011
Date of revision:
Handle: RePEc:ris:uncgec:2011_008
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