The carbon tax as an automatic stabilizer in a commodity-producing Small Open Economy

Abstract

In this paper, we evaluate the role of carbon taxes as automatic stabilizers in small open economies (SOEs) that specialize in the export of a single commodity, particularly those highly dependent on energy inputs for production. Specifically, we examine the carbon tax’s ability to reduce the volatility of the real exchange rate and energy prices. This analysis is conducted through the lens of a DSGE model that incorporates an externality affecting GDP, originating from the burning of fossil fuels for energy generation. We assume this externality drives climate change, and the government, aiming to internalize these damages, imposes a Pigouvian tax on the energy sector. Our model is calibrated for the Chilean economy, which is highly specialized in copper production. The results show that the tax: (i) reduces energy volatility by 14% and energy price volatility by 10%, and (ii) lowers the variance of the real exchange rate by 1.8%. These stabilizing effects are robust to different shock specifications and the choice of model used to represent household consumption.