NGFS-GRASFI-INSPIRE exchange – Green monetary policy: Implications for emissions, investment and inflation

Kai Lessmann (Potsdam Institute for Climate Impact Research) and Emanuel Moench (Frankfurt School of Finance and Management) will present their research “Green monetary policy: Implications for emissions, investment and inflation”, co-authored with Andrew McConnell (Potsdam Institute for Climate Impact Research) and Boyan Yanovski (Potsdam Institute for Climate Impact Research).

The NGFS-GRASFI-INSPIRE exchange is designed to strengthen the connection, collaboration and research exchange between the central bankers, financial supervisors and the academic community to share and explore new and innovative research that advances the agenda on greening the financial system. New editions occur monthly and are co-organised by the NGFS Secretariat, INSPIRE and GRASFI (the NGFS’ two designated global research stakeholders). This is the final session in a five-part series focused on the impacts and limitations of green monetary policy.  This 15th edition is hosted by the NGFS.

Central bank collateral as a green monetary policy instrument

14 December: Central banks can play an important role in the transition towards a climate-neutral economy. This paper discusses different green monetary policy instruments along the dimensions of feasibility of implementation and impact on the transition process. We identify the inclusion of ‘brown’ collateral haircuts into a central bank’s collateralized lending framework as the most promising conduit of green monetary policy. The impact of such interventions on the real economy is then formally explored by extending a general equilibrium transition model to include a simple banking sector with central bank lending facilities and collateral adjustments. We find that both ‘brown’ collateral haircuts and ‘green hairgrowth’ increase carbon neutral investment while decreasing carbon intensive investment and emissions. Consequently, in addition to decreasing the exposure of the central bank balance sheet to climate-related risks, climate-based collateral adjustments have the potential of increasing the political feasibility of a timely transition to a carbon neutral economy by affecting emission levels. Despite ‘green hairgrowth’ having a stronger effect on investment and emissions, ‘brown’ collateral haircuts remain the recommended policy as the former is not necessarily ‘market neutral’ and thus cannot be broadly applied across central banks.

Key policy insights

  • ‘Brown’ collateral constraints as green monetary policy is a feasible instrument that can be broadly implemented across different central bank frameworks and mandates.

  • ‘Brown’ collateral haircuts increase the financing costs and decrease the volume of carbon intensive investments.

  • ‘Green hairgrowth’ has a similar effect but is in conflict with market neutrality and, therefore, not as broadly implementable.

  • The synergy of a price instrument and ‘brown’ collateral constraints results in a significantly lower and potentially politically more feasible carbon tax.

Implications for Emissions, Investment, and Inflation

Over recent years several instruments for green central bank monetary policy have been proposed but little to no modelling rigour has been applied to further substantiate the debate. We draw on theoretical modelling and numerical simulation to assess two specific proposals of green monetary policy: the greening of central bank collateral frameworks, and targeted green refinancing operations. We hope to deepen our theoretical understanding of these instruments and quantify their impact on the economy and environment. To do so, we draw on formal modelling that can account for cumulative emissions, differentiated investment (based on carbon emissions), economic growth, monetary policy, and inflation.

Our model will be the first to integrate all of these five aspects which are all essential to our research question. The inclusion of monetary policy is self‐explanatory. However, the final requirement, inflation, is often neglected within climate policy analysis. Within the context of green monetary policy, inflation becomes particularly important as it is the principle aim of modern central bank mandates and climate change might create “cost‐push” or “demand‐pull” inflation.

In order to inform policymakers of the potential effects of green collateral frameworks and green refinancing operations, we propose including inflation and monetary policy into a dynamic general equilibrium model that includes a banking model, differentiated sectors (based on carbon emissions), and conventional climate polity. In addition to observing the effects of green monetary policy on emissions and investment, this model would also allow us to analyse the potential trade‐off between climate change mitigation and inflation, which might have large-scale ramifications for social welfare.