The Optimal Mix of Monetary and Climate Policy

This research theoretically investigates the mix of monetary and climate policy and provides insights for central banks that are considering their engagement in the climate change issue. The “climate-augmented” monetary policy is pioneeringly proposed and studied.

Our research method is an extended Environmental Dynamic Stochastic General Equilibrium (E-DSGE) model. The basic DSGE setting is in line with the standard New Keynesian framework. The “Environmental” features are introduced by incorporating the greenhouse gas emissions from production, their negative externality on productivity, and the climate policy that controls emissions, i.e., cap-and-trade or carbon tax.

Based on the model, we preliminarily find the following results:

• The process of developing monetary policy should consider the existing climate policy since it is a factor that can influence price level and inflation.
• The reaction coefficients in traditional monetary policy rule can be better set to enhance welfare when climate policy is given. This provides a way to optimise the policy mix.
• If a typical-form climate target is augmented into the monetary policy rule, a dilemma could be created. This means that it has some risks for central banks to care for the climate proactively by using the narrow monetary policy (interest rate).