Greenflation?

September2023

ConnyOlovssonandDavidVestin

Humansaffecttheclimatebyemittinggreenhousegasesinto theatmosphereandthiscontributestoglobalwarming(IPCC, 2021).

Somecountrieshaveintroducedpoliciestoreduceemissions. Fearof greenflation,i.e.,upwardpressuresoninflationfrom higherenergyprices(speechbySchnabel,2022).

Humansaffecttheclimatebyemittinggreenhousegasesinto theatmosphereandthiscontributestoglobalwarming(IPCC, 2021).

Somecountrieshaveintroducedpoliciestoreduceemissions. Fearof greenflation,i.e.,upwardpressuresoninflationfrom higherenergyprices(speechbySchnabel,2022).

Researchquestions:

1 Whataretherealandinflationaryimplicationsfromagreen transition?

2 Howshouldmonetarypolicyreactduringthetransition?

TheNew-Keynesianmodel

TheNew-Keynesianmodel

Thereisahouseholdthatconsumesaconsumptiongood, C , andprovideslabor, H.

TheNew-Keynesianmodel

Thereisahouseholdthatconsumesaconsumptiongood, C , andprovideslabor, H.

C isaCESaggregateofamanufacturedgood, Cg ,and energyservices, E .

TheNew-Keynesianmodel

Thereisahouseholdthatconsumesaconsumptiongood, C , andprovideslabor, H.

C isaCESaggregateofamanufacturedgood, Cg ,and energyservices, E .

Fossilfuel, E1,andgreenenergy, E2,arebothproducedwith laborastheonlyinput.

TheNew-Keynesianmodel

Thereisahouseholdthatconsumesaconsumptiongood, C , andprovideslabor, H.

C isaCESaggregateofamanufacturedgood, Cg ,and energyservices, E .

Fossilfuel, E1,andgreenenergy, E2,arebothproducedwith laborastheonlyinput.

E areproducedbycombining E1 and E2 usingaCES aggregator.

TheNew-Keynesianmodel

Thereisahouseholdthatconsumesaconsumptiongood, C , andprovideslabor, H.

C isaCESaggregateofamanufacturedgood, Cg ,and energyservices, E .

Fossilfuel, E1,andgreenenergy, E2,arebothproducedwith laborastheonlyinput.

E areproducedbycombining E1 and E2 usingaCES aggregator.

Productionofgoodsrequires E and H asinputsandit featuresmonopolisticcompetitionandCalvopricing.

TheNew-Keynesianmodel

Thereisahouseholdthatconsumesaconsumptiongood, C , andprovideslabor, H.

C isaCESaggregateofamanufacturedgood, Cg ,and energyservices, E .

Fossilfuel, E1,andgreenenergy, E2,arebothproducedwith laborastheonlyinput.

E areproducedbycombining E1 and E2 usingaCES aggregator.

Productionofgoodsrequires E and H asinputsandit featuresmonopolisticcompetitionandCalvopricing. Wages, W ,andconsumption-goodsprices, Pg ,aresticky, energypricesflexible.

ThepolicylooselyresemblestheFit-For-55programinEU:a carbontax, τ ,increaseslinearlyupto2040sothatfossil energyusefallsbyabout60%,afterwhichitremains constant.

Fiscalandmonetarypolicy

ThepolicylooselyresemblestheFit-For-55programinEU:a carbontax, τ ,increaseslinearlyupto2040sothatfossil energyusefallsbyabout60%,afterwhichitremains constant.

Noclimatepolicytoreduceemissionsintherestoftheworld.

ThepolicylooselyresemblestheFit-For-55programinEU:a carbontax, τ ,increaseslinearlyupto2040sothatfossil energyusefallsbyabout60%,afterwhichitremains constant.

Noclimatepolicytoreduceemissionsintherestoftheworld.

MonetarypolicyfollowssimpleTaylorruleswithinflationas theonlytargetandwhereinflationcanbeheadline,core,or wageinflation.

Flexibleprices:Theefficientgreentransition(EGT)

Thetransitionintheflex-priceeconomyprovidestheleast costlywaytoachieveaspecific desired reductionindomestic fossilfueluse.

Flexibleprices:Theefficientgreentransition(EGT)

Thetransitionintheflex-priceeconomyprovidestheleast costlywaytoachieveaspecific desired reductionindomestic fossilfueluse.

Wethereforerefertotheflex-priceallocationasthe efficent greentransition.

Thetransitionintheflex-priceeconomyprovidestheleast costlywaytoachieveaspecific desired reductionindomestic fossilfueluse.

Wethereforerefertotheflex-priceallocationasthe efficent greentransition.

Theflex-priceversionisaRBCmodelwithflexiblenominal pricesandwagesanditcanbesolvedinclosedform.

Flexibleprices:Therequired real-price changes

Therealwageisdecreasinginthecarbontax.

Therealpriceofgoodsisdecreasinginthecarbontax.

Therealpriceofenergyisincreasinginthecarbontax.

Flexibleprices:Therequired real-price changes

Therealwageisdecreasinginthecarbontax.

Therealpriceofgoodsisdecreasinginthecarbontax.

Therealpriceofenergyisincreasinginthecarbontax.

w fallsbecausethepolicyiscostlybutithasnoeffecton globalemissions

Flexibleprices:Therequired real-price changes

Therealwageisdecreasinginthecarbontax.

Therealpriceofgoodsisdecreasinginthecarbontax.

Therealpriceofenergyisincreasinginthecarbontax.

w fallsbecausethepolicyiscostlybutithasnoeffecton globalemissions

EUaccountsforabout7%ofglobalemissionsandthebenefits arespreadoutonallcountries.

Resultswithstickypricesandwages

Proposition

Ifenergy isnot usedinproductionandnominalwagesandgoods pricescannotadjust,aflexibleenergypriceandamonetarypolicy rulethatseesthroughenergy-pricechangesaresufficientto implementEGT.

Resultswithstickypricesandwages

Proposition

Ifenergy isnot usedinproductionandnominalwagesandgoods pricescannotadjust,aflexibleenergypriceandamonetarypolicy rulethatseesthroughenergy-pricechangesaresufficientto implementEGT.

Let Pe ⇑ toincrease P,whichlowers w ≡ W P and pg ≡ Pg P .

Resultswithstickypricesandwages

Proposition

Ifenergy isnot usedinproductionandnominalwagesandgoods pricescannotadjust,aflexibleenergypriceandamonetarypolicy rulethatseesthroughenergy-pricechangesaresufficientto implementEGT.

Let Pe ⇑ toincrease P,whichlowers w ≡ W P and pg ≡ Pg P .

Proposition

Ifenergy is usedinproductionandnominalwagesandgoodsprices cannotadjust,aflexibleenergypriceandamonetarypolicyrule thatseesthroughenergy-pricechangesarenolongersufficientto implementEGT.

Resultswithstickypricesandwages

Proposition

Ifenergy isnot usedinproductionandnominalwagesandgoods pricescannotadjust,aflexibleenergypriceandamonetarypolicy rulethatseesthroughenergy-pricechangesaresufficientto implementEGT.

Let Pe ⇑ toincrease P,whichlowers w ≡ W P and pg ≡

Proposition

Ifenergy is usedinproductionandnominalwagesandgoodsprices cannotadjust,aflexibleenergypriceandamonetarypolicyrule thatseesthroughenergy-pricechangesarenolongersufficientto implementEGT.

Nowtherewillbedeviationsfromefficiency.Howlarge?

Thesizeofthedeviationfromefficiency

Dependsonthe(CES–)weightonenergyinproduction, γ, andhowaggressively τ isincreased.

Dependsonthe(CES–)weightonenergyinproduction, γ, andhowaggressively τ isincreased.

γ ≈ 0.03–0.05(i.e.,closeto0).

Dependsonthe(CES–)weightonenergyinproduction, γ, andhowaggressively τ isincreased.

γ ≈ 0.03–0.05(i.e.,closeto0).

IntheFF55,thetaxisphasedin,i.e.,onlysmallchangesat eachpointintime.

Dependsonthe(CES–)weightonenergyinproduction, γ, andhowaggressively τ isincreased.

γ ≈ 0.03–0.05(i.e.,closeto0).

IntheFF55,thetaxisphasedin,i.e.,onlysmallchangesat eachpointintime.

Hence,therewillonlybesmalldeviationsfromtheefficient pricesandfromtheEGTifMPseesthroughtheenergyprice change.

Inflationaryconsequences

Weshowthat

Inflationaryconsequences

Weshowthat

1 inflation,ateachpointintime,isafunctionofthecurrentand allfuturerealinterestrates.

Weshowthat

1 inflation,ateachpointintime,isafunctionofthecurrentand allfuturerealinterestrates.

2 Realinterestratesduringthetransitionwillbe below the steadystatevalue.

Inflationaryconsequences

Weshowthat

1 inflation,ateachpointintime,isafunctionofthecurrentand allfuturerealinterestrates.

2 Realinterestratesduringthetransitionwillbe below the steadystatevalue. Hence,thetransitiongeneratesdownwardpressureson inflation!

Inflationaryconsequences

Weshowthat

1 inflation,ateachpointintime,isafunctionofthecurrentand allfuturerealinterestrates.

2 Realinterestratesduringthetransitionwillbe below the steadystatevalue.

Hence,thetransitiongeneratesdownwardpressureson inflation!

HowmuchdependsontheweightintheTaylorruleofbeing ontarget.

Inflationaryconsequences

Weshowthat

1 inflation,ateachpointintime,isafunctionofthecurrentand allfuturerealinterestrates.

2 Realinterestratesduringthetransitionwillbe below the steadystatevalue.

Hence,thetransitiongeneratesdownwardpressureson inflation!

HowmuchdependsontheweightintheTaylorruleofbeing ontarget.

Withahighenoughweight,inflationcanbedriventotarget.

Inflationaryconsequences

Weshowthat

1 inflation,ateachpointintime,isafunctionofthecurrentand allfuturerealinterestrates.

2 Realinterestratesduringthetransitionwillbe below the steadystatevalue.

Hence,thetransitiongeneratesdownwardpressureson inflation!

HowmuchdependsontheweightintheTaylorruleofbeing ontarget.

Withahighenoughweight,inflationcanbedriventotarget.

Inaflex-priceeconomythishasnocost.

Nominalrigidities1:stickygoodspricesandflexiblewages

Ifboth W and Pe areflexible,EGTcanbeimplementedeven if Pg issticky—butonlyifmonetarypolicyiscorrectly designed.

Nominalrigidities1:stickygoodspricesandflexiblewages

Ifboth W and Pe areflexible,EGTcanbeimplementedeven if Pg issticky—butonlyifmonetarypolicyiscorrectly designed.

AmonetarypolicyrulethattargetsCPIinflationcouldnever beefficienthere.

Wouldrequire Pg ⇓ when Pe ⇑,whichwouldresultinan inefficientallocationofgoods(Aoki,2001).

Nominalrigidities1:stickygoodspricesandflexiblewages

Ifboth W and Pe areflexible,EGTcanbeimplementedeven if Pg issticky—butonlyifmonetarypolicyiscorrectly designed.

AmonetarypolicyrulethattargetsCPIinflationcouldnever beefficienthere.

Wouldrequire Pg ⇓ when Pe ⇑,whichwouldresultinan inefficientallocationofgoods(Aoki,2001).

Solution

useaTaylorrulethattargetscoreinflation—CPI–energy inflation—and

Set απ highenoughtomakesurethatcoreinflationdoesnot move.

Nominalrigidities1:stickygoodspricesandflexiblewages

Ifboth W and Pe areflexible,EGTcanbeimplementedeven if Pg issticky—butonlyifmonetarypolicyiscorrectly designed.

AmonetarypolicyrulethattargetsCPIinflationcouldnever beefficienthere.

Wouldrequire Pg ⇓ when Pe ⇑,whichwouldresultinan inefficientallocationofgoods(Aoki,2001).

Solution

useaTaylorrulethattargetscoreinflation—CPI–energy inflation—and

Set απ highenoughtomakesurethatcoreinflationdoesnot move.

W and Pe canthenadjustsothatEGTisreplicated.

B.L.: Pe ⇑⇒ CPI ⇑≤ 0.5%.

Πremainslowanditisnotcostlysincewearereplicatingthe EGT.

B.L.: Pe ⇑⇒ CPI ⇑≤ 0.5%.

Πremainslowanditisnotcostlysincewearereplicatingthe EGT.

Resultsaresimilarwhen W and Pg arebothsticky.

Potentialissuesthatcouldbeincorporated

Greenandbrowncapital.

Similartogreentechnicalchange.

Carbontaxesversusgreensubsidies.

Willnotlikelyreduceemissions,buttheaboveframework couldbeusedtoanalysetheeffectsoninflation.

Climatechange.

Willnotchangethemainconclusions.

Couldexpectationsmoveifheadlinegoesabovetarget?

Conclusions

Weshowthatagreentransitionrequiresthe pe ⇑ and pg ⇓, mc ⇓,and w ⇓.

Itisoptimalforthecentralbanktoseethroughtheincreasing energypricesandfocusoncoreinflation.

Theresultisamodest greenflation.

TheseresultsareinlinewiththeempiricalfindingsinKonradt andWederdiMauro(JEEA,2023),showingonlylimited effectsoninflationfromgreenpolicies.

ContrastswithAiraudoetal.(2023):“Permanentincreases inbrownenergypricesinduceagreentransitionwith short-runinflationandpersistentoutputlosses.”