Carbon pricing, trade and the natural rate

Introducing carbon pricing increases production costs and reduces output, at least initially. Benefits from reduced emissions damage materialize only later. This affects households' saving behavior and, thereby, the natural interest rate r*. Using a dynamic, three-region environmental life-cycle model, we find that the effects on the natural interest rate and net foreign asset positions crucially depend on how govern- ments recycle carbon revenues. If carbon revenues are paid back to all households in a lump-sum manner, saving declines, the natural rate increases permanently and the net foreign asset position of the carbon pricing-increasing country falls. The opposite holds if only the working-age population benefits from carbon revenues. The impact on exchange rates and trade flows depends on which regions introduce carbon pricing (and potential border adjustment mechanisms) as this ultimately drives relative price changes across the regions.