Climateflation and monetary policy in an environmental OLG growth model

Recent empirical evidence is challenging the conventional paradigm in macroeconomics, which assumes money is neutral in the long run. On the other hand, central banks are gradually acknowledging that climate change can potentially impact price stability, and the term climateflation has entered the vocabulary of policymakers. This paper contributes to current developments between these two major themes. We present an Overlapping Generations (OLG) model to study the interplay between conventional monetary policy and the environment in a context where the so-called “independence hypothesis” does not hold. Individuals are assumed to derive utility from consumption and environmental quality. Firms operate in a competitive market, but output is weighted by a damage function reflecting a negative externality from ecological degradation. We innovate by linking the environment to inflation through inflationary expectations in a modified Phillips curve. Central banks set the nominal interest rate using a generalised Taylor rule. They affect wealth composition via the individual’s intertemporal optimisation problem. Numerical experiments allow us to assess the robustness of the trade-off between environmental quality and economic activity when (i) expectations are more responsive to climateflation, (ii) the monetary authority is more inflation-averse, (iii) the central bank increases the inflation target, and (iv) fiscal policy is less stringent.