The Role of Monetary Policy Under a Low-carbon Transition

We assess the implications for monetary policy action under a zero-carbon transition. Via a more stringent climate policy, the transition can result in both demand- and supply-side shocks. We seek to provide insights on the potential monetary policy responses to a climate policy shock by modelling the economic impacts using the multi-country, multi-sector model of the global economy, G-cubed. We draw on literature to define robust rules and we will consider rules that are uniform across regions, as well as differing rules in order to better replicate real-world monetary policy responses.

Our results suggest that a carbon tax consistent with 2° C of warming leads to a clear monetary policy trade-off, with higher inflation and a negative output gap. For the majority of countries, the impact on inflation outweighs that on output growth in the short term, whereas in the long term, the impact on output growth dominates, leading to a reduction in policy rates. The policy rate remains permanently lower once the shock has dissipated, suggesting that a persistent tax on carbon will lead to lower potential output and a lower neutral interest rate. Such a large tax on carbon would need to be accompanied by a large increase in productivity to offset the impact on potential output and long-term interest rates.

The shocks required to achieve ambitious targets lead to large negative impacts on emissions-intensive sectors. It’s difficult to assess how the transition to low-carbon energy sources will occur whilst also capturing the impacts on the rest of the economy.