A New Keynesian Model to Assess the Role of Government Preferences over Climate Investments

This paper develops a New Keynesian Environmental Dynamic Stochastic General Equilibrium (EDSGE) model to analyze the role of government investment in facilitating the transition to a green economy. We extend the standard framework by incorporating two types of capital—polluting (brown) and non-polluting (green)—both of which are used in production. Firms choose their capital mix while being subject to carbon taxation, and the government directly invests in capital formation, with preferences over green and brown investments. The model includes adjustment costs for the production of green capital, capturing the frictions associated with its deployment and the slow adaptation of firms to green alternatives. Our analysis explores the macroeconomic and environmental effects of fiscal policy under different government investment preferences. We find that when the government invests only in brown capital, the crowding-out effect on private investment leads to lower output, reduced consumption, and increased emissions. In contrast, when the government prioritizes green capital, economic growth accelerates while emissions decline, despite the presence of a private investment crowd-out effect. A mixed investment strategy, where the government allocates resources to both types of capital but still favors brown investment, yields results similar to the green-focused scenario but with more moderate effects. A key result of our analysis is that both the full-green and mixed investment strategies reduce the returns on green capital, highlighting that targeted government policies can mitigate production frictions in green capital accumulation. This result underscores the importance of public sector intervention in lowering the financial barriers to green investment and ensuring a smoother transition toward a more sustainable production structure. Moreover, our findings emphasize the broader policy trade-offs involved in financing the green transition. While carbon taxation effectively reduces emissions, its interaction with investment decisions creates supply-side constraints that could slow economic growth if not accompanied by complementary public investment. Overall, our research highlights the pivotal role of government intervention in shaping the dynamics of green transition. By explicitly modeling capital accumulation frictions, carbon taxation, and government investment preferences, we provide a framework that can be used to evaluate climate policies when private sector adaptation is constrained. Our findings reinforce the argument that proactive fiscal policies are highly recommended to align economic incentives with long-term environmental goals, ensuring that the transition to a greener economy is both economically viable and socially optimal.