Monetary Policy: the trade-off between being green or not

Montevideo

Seminario; Arnoldshain Seminar XVIII Current Challenges in International Economics; 2024

Universidad de la República

We proceed to analyze the implementation of a Monetary Policy aimed at promoting the financing of "green" activities in search of lower carbon emission levels. A decrease in the inflation rate would be expected due to the increase in production and the change in relative prices -leading to an increasing productivity of green factors- and also as a consequence of positive externalities, causing a reallocation of resources towards green sectors. As an example, let us assume that there are only two types of production processes (which would be equivalent to using carbon inputs and green inputs): a polluting one or Carbon Production Process? (CPP) and another, non-polluting or Green Production Process? (GPP). We can initially assume that this economy is characterized by the existence of mostly polluting production processes. If the Central Bank were now to implement an expansionary monetary policy aimed at granting targeted discounts to be canalized by banks towards green-project funding, this would result in a change in relative prices that would make such projects more attractive. Thus, if the projects that were previously implemented are not favored with the new funds and a change in relative prices is observed, the Production Possibilities Frontier (PPF) could be expanded, promoting green projects.A new PPF could be reached, and further expansions are expected. The effects on inflation would be indeterminate, depending on the weights assigned in the price index to goods produced with GPP relative to those with CPP. However, one can expect a long-run shift in the consumption basket as it tilts towards more efficiently produced goods. If holding the consumption basket unaltered, the overall permanent increase in productivity must imply a decrease in the inflation rate in the long run.So far, we have presented the expected and most desirable story, but these results would only naturally arise in the context of monetary dominance in the policy conducted by the Central Bank. What would happen with inflation in the context of a non-independent Monetary Authority? Based on Masciandaro and Russo (2022, 2023), we develop a model where the objective of the consolidated government is to maximize an aggregate government spending function considering the inflation rate, the output gap, and the cost of credit.The model considers the possibility of increasing targeted credit towards green projects, in the need to reduce the volume of carbon dioxide emissions.