Essays on Climatic Disruptions and Monetary Policy

Abstract

This thesis consists of four research papers that examine the macroeconomic effects of climate change and the implications for the conduct and design of optimal monetary policy.

The first paper (joint with Warwick McKibbin) examines alternative monetary regimes and evaluates the performance of the conventional inflation targeting framework from the standpoint of Australia. Specifically, the paper examines (i) how well each monetary regime can handle supply shocks; (ii) the challenges associated with the measurement and communication of target variables under alternative monetary regimes, particularly for indicators whose real-time measurements are subject to relatively larger errors in a climatically disrupted world; (iii) the forecastability of the target variables under each monetary regime; and (iv) the ability of the conventional inflation targeting regime to credibly anchor price expectations under conditions of persistent supply-side disruptions.

The second and third papers build on the arguments from the first paper by revisiting the measurement and forecastability problems facing inflation-targeting central banks in a carbon-constrained and climatically disrupted macroeconomy. The second paper tests the hypothesis that the inclusion of climate effects in the estimation of potential output can improve real-time estimates of the output gap, with Australia as a case study. Using variations in temperature and precipitation 'anomalies' as proxies for climatic conditions over time, the paper employs an unobserved component model estimated by the data-driven Maximum Likelihood technique in the state-space context to derive climate-neutral measures of potential output and the output gaps. The results show that potential output and output gap measures that are adjusted for climatic disruptions are relatively more accurate in real time than those obtained from conventional approaches that do not take climate effects into consideration

The third paper employs a Bayesian-estimated structural multivariate filtering model calibrated to data for Australia and the United States, innovatively incorporating climate hysteresis into the estimation of potential output and the output and unemployment gaps. The results suggest non-trivial implications for monetary policy in a climatically disrupted world, with different implications for inflation signals during the upturn or downturn of the business cycle. Specifically, macroeconomic slacks are smaller when both actual conditions and potential supply capacity are modelled to change simultaneously, with recessions that may be less disinflationary, and booms that may be less inflationary.

The final paper, forthcoming in the Oxford Review of Economic Policy (joint with Warwick McKibbin, Adele Morris and Peter Wilcoxen) explores the interaction of climate change and monetary policy as they jointly influence macroeconomic outcomes, employing a general equilibrium model with full sectoral disaggregation of the energy generation sectors and strong global linkages in capital and trade. The results show that a central bank that targets the growth in nominal income outperforms one that is focused on flexibly balancing price and output stability goals in a carbon-constrained environment. Overall, the interaction between climate policy and monetary policy strongly suggests that the two policy frameworks should be jointly evaluated. Managing each regime separately can easily lead to policies that seem optimal in isolation, but that perform very poorly in practice.