Incorporating Climate Change
and Green GDP in Monetary
Policy
Peter Sinclair
Bank Indonesia Annual International Seminar on the Macroeconomic Impact
Global warming may prove to be exaggerated.
We do not yet know.
• We shall learn more as time goes on.This talk looks first at how gw could affect the macroeconomy; second, at how
developing knowledge could affect it; third, at specific monetary policy implications;
What is the simplest way of modelling the macroeconomics of climate change?
• Carbon emissions from burning fossil fuel are the dominant (but not only) element in gw
• Aggregate output is inhibited by them • So make the rate of extraction of fossil
We combine this idea with standard
ideas
• Hotelling’s rule, linking the rate of change of the expected excess of margianl
revenue over marginal extraction cost, adjusted for any tax, to the rate of return on capital
• This holds as a portfolio equilibrium
Also add
• A Cobb Douglas aggregate production
function depending on capital, labour and inputs of energy
• Labour augmenting technical progress, which decreases as the resource
extraction rate rises
This model, with some simplification, generates an infinite horizon steady state
• GW reduces the SS real interest rate
• It also lowers the SS growth rate of real income • And the rate of fossil fuel extraction also falls (a
crumb of comfort)
• The more serious the GW phenomenon, the larger these 3 reductions
If we discover that GW is more
(less) serious than we thought:
• And assuming rational expectations, immediate repercussions include:
• Anticipation of a gradual asymptotic reduction (rise) in real interest rates towards their new level
• A sudden ujump (drop) in real oil prices, required by Hotelling’s rule
And finally adjustment towards a
permanently lower (higher) growth rate.
Some further effects
• Unanticipated discovery of an inexpensive and largely effective (costless and 100% effective) method of capturing carbon will reduce (remove) the adverse effect of
extarction on technical progress. Result: higher real interest, and extraction, and
And if expectations of such
discoveries in the future go up?
• We now anticipate these changes at that future date, with (muted) current impact, so oil prices fall somewhat now,
unfortunately increasing current harmful
fossil fuel extraction and exacerbating GW until the new carbon sequestration
A similar result – a fall in oil prices
now
• Would follow if there were an
unanticipated discovery now of a new and cheaper source of non-fossil fuel
technology
• Or an increase expectation now of this at some future date
Monetary Policy Implications?
• At first glance negligible, especially if we think that long run equilibrium values of real variables are independent of the level or growth rate of
nominal monetary aggregates
• Fiscal policy might lower the rate of extraction – especially if ad valorem oil taxes have a
DECLINING trend
If GW lowers long run real interest
rates
• The neutral nominal rate associated with a given inflation target will (very gradually) come down.
• If there are changing patterns of
And that, from Hotelling, could cause violent swings in real oil prices
• Compared with a nonGW world, headline inflation would become relatively harder to target than core (ex-oil) inflation;
• And nominal income targeting would become easier than inflation targeting; • And (equilibrium) real exchange rates
In the longer run
• Rapid GW could create the need for new giant mega projects, eg damming the
Skagerrak and the Mediterranean, and protecting valuable real estate and
population centres in the Pacific Rim.
These would tend to drive up the cost of capital, temporarily
Lastly, Green GDP
• Technically a misnomer! But appropriate to redefine depreciation to include depletion of nature’s bounty, and apply an expenditure tax widened to reflect this;
• Redefinition of depletable resource trade as a capital account item on the balance of payments • Externality-internalizing taxation? Yes – but may
