Toward a Green Economy

In this working paper published by the European Central Bank (ECB), macroeconomics experts Alessandro Ferrari and Valerio Nispi Landi find that green quantitative easing by central banks would be most effective in reducing emissions if used “aggressively and immediately”.

The authors emphasise that a carbon tax is most effective in reducing emissions in the long term, whereas green quantitative easing is best used as a medium-to-short term measure while carbon taxes remain low or absent. If carbon taxes are already high, the link between production and emissions is weakened and the effectiveness of green quantitative easing is reduced.

The paper uses a dynamic stochastic general equilibrium model to study the efficacy of quantitative easing along the transition to a carbon-free economy and eventually establishing an emissions tax. The results show that green quantitative easing is likely to have a fairly modest but positive effect on overall emissions, by shifting demand from carbon-intensive sectors towards green ones in advance of adequate carbon tax schemes.

The paper also models market neutral quantitative easing and notes that results are consistent with previous research, which found a carbon bias in the ECB’s corporate bond holdings, as well as a Bank of Italy working paper which showed that market neutral quantitative easing raises overall emissions.

The authors also report that green quantitative easing can be implemented without conflicting with primary mandates, adding that it may be a useful complement to a carbon tax if used early in transition by stimulating production and prices. They argue this could partially offset the potentially deflationary impact of introducing a carbon tax on nominal interest rates.

The results also show that a crucial parameter to determine the effectiveness of green quantitative easing is the elasticity of substitution between the carbon-intensive and green bonds.

The authors conclude with the caveat that the model underestimates the impact of climate change on the economy, as it does not include climate-economy feedback effects. They recommend that future research include such feedback effects, as well as other relevant channels such as the impact of green technology, research and development, and changes in investment behaviour as a result of signalling effects.