How should environmental policy respond to business cycles? Optimal policy under persistent productivity shocks

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Abstract

How should environmental policy respond to economic fluctuations caused by persistent productivity shocks? This paper answers that question using a dynamic stochastic general equilibrium real business cycle model that includes a pollution externality. I first estimate the relationship between the cyclical components of carbon dioxide emissions and US GDP and find it to be inelastic. Using this result to calibrate the model, I find that optimal policy allows carbon emissions to be procyclical: increasing during expansions and decreasing during recessions. However, optimal policy dampens the procyclicality of emissions compared to the unregulated case. A price effect from costlier abatement during booms outweighs an income effect of greater demand for clean air. I also model a decentralized economy, where government chooses an emissions tax or quantity restriction and firms and consumers respond. The optimal emissions tax rate and the optimal emissions quota are both procyclical: during recessions, the tax rate and the emissions quota both decrease. © 2011 Elsevier Inc.

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Heutel, G. (2012). How should environmental policy respond to business cycles? Optimal policy under persistent productivity shocks. Review of Economic Dynamics, 15(2), 244–264. https://doi.org/10.1016/j.red.2011.05.002

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