Short-term macroeconomics and climate policy: a few lessons from an aggregate demand and supply model

• Published in: Recherches économiques de Louvain Vol. 80; no. 1; pp. 31 - 60
• Main Authors: Fagnart, Jean-François, Germain, Marc
• Format: Journal Article
• Language: English; French
• Published: 01-01-2014
• Subjects: Aggregate demand; Aggregate supply; Carbon emissions; Climate change; Environmental policy; Environmental tax; Macroeconomics; Pollution
• ISSN: 0770-4518
• DOI: 10.3917/rel.801.0031

We introduce the concept of carbon footprint into an aggregate demand and supply model with imperfectly competitive price and wage formation. We analyse the properties of the short-term macroeconomic equilibrium in the presence of a climate policy, which may take the form either of a carbon tax or of quotas of pollution permits. We show that in the short run climate policy (or its strengthening) is simultaneously a negative aggregate supply shock and a positive aggregate demand shock. It is thus inflationary but it has an ambiguous impact on aggregate economic activity and employment: it will only stimulate output in an economy where nominal wages are rigid enough. In all cases, climate policy will depress real wages. We also analyse the interactions between climate policy and the usual macroeconomic policies of demand (fiscal and monetary stimuli) and supply (labour tax cut). The multiplier effects of these demand and supply policies depend on the instrument chosen for implementing the climate policy (carbon tax or pollution permits). We finally establish the conditions under which a reform combining a climate policy strengthening and a labour tax cut can reach the double objective of a lower carbon footprint and a lower unemployment rate, without reducing workers' real wages. Such a policy reform has however an ambiguous impact on the government surplus (or deficit). Reproduced by permission of Bibliothèque de Sciences Po