Climate Actions, Market Beliefs and Monetary Policy

March 26, 2024Published by Journal of Economic Behavior and Organization

Markets are made up of sometimes irrational and inherently diverse human actors, yet economics research typically assumes markets will behave in line with “perfect rationality”.

According to this paper for the Journal of Economic Behavior and Organization, non-rational market players wrongly perceive climate actions as temporary shocks, overlooking the structural changes they represent.

Authors Barbara Annicchiarico, Fabio Di Dio and Francesca Diluiso consider the implications of this for central bank’s price stability mandates.

The paper’s authors leveraged advances in behavioural modelling to move beyond the standard assumption of perfectly rational market expectations, towards a more true-to-life analysis of the macroeconomic impact of climate policies.

They found that the presence of behavioural biases or “bounded rationality” may prevent markets from fully internalising the impact of climate policies, amplifying business cycle fluctuations, destabilising prices and placing upwards pressure on inflation.

Such negative impacts would be worsened in a delayed transition scenario, which increases uncertainty and the chance of market forecast errors.

The authors explore central banks’ role in reducing such risks. By using reactive monetary policy, central banks can anchor the inflationary expectations which may be otherwise destabilised by rapidly shifting “waves” of optimism and pessimism in response to climate policies.

“Under the central bank’s more vigorous stabilisation effort, there is no longer a trade-off between inflation control and climate policy: more price stability can be achieved without leading to more uncertainty about meeting the climate target,” the paper states.

The authors use a New Keynesian behavioural model to incorporate expectations of four kinds of economic actors. This allowed them to model different market segments endogenously selecting varied expectations regarding the consequences of climate policy on inflation and income.

The paper then explores four possible central bank reactions and finds that the worst performing monetary policy responses are backward-looking ones, or those based on market expectations. The latter approach is expected to be the most damaging as it intermittently validates “wrong expectations”.

Forward-looking approaches and those that react to present macroeconomic conditions, rather than market expectations, were found to be the best performing.

Another key finding from the paper is that, under a behavioural model, cap-and-trade schemes can pose a “severe threat” to price stability without central bank intervention.

By introducing excessive volatility to the time path of emissions prices, maintaining price stability will prove substantially harder under a cap-and trade system than under a carbon tax.

However, achieving the desired emissions reductions using a carbon tax takes double the time than previously assumed in the context of perfect rationality. This delay results in a lower cumulative reduction of emissions of 2.3%.

The authors also argue that more ambitious climate actions can pose challenges to debt stability. However, they demonstrate that if sufficiently corrective actions to stabilise debt are implemented, for example through more stringent monetary policy and stabilising fiscal rules, uncertainty surrounding how the debt ratio will respond to climate policy can be reduced.

This page was last updated March 26, 2024

Share this article