Climate Actions, Market Beliefs, and Monetary Policy

Abstract

This paper studies the role of expectations and monetary policy in shaping the response of the economy to climate actions. We show that in a stochastic environment and without the standard assumption of perfect rationality of agents, there is more uncertainty regarding the time-path and the impact of a climate policy on the economy. The state of the economy and market beliefs determine the effectiveness of a mitigation plan implemented through carbon pricing. Climate actions may be frustrated by the presence of agents lacking the cognitive abilities necessary to form rational expectations. Monetary policy may reduce the uncertainty surrounding the impact of climate policies and may support the greening process.