ProdukHukum BankIndonesia

Incorporating Climate Change
and Green GDP in Monetary
Policy
Peter Sinclair
Bank Indonesia Annual International
Seminar on the Macroeconomic Impact
of Climate Change, Bali, August 2008

Global warming may prove to be
exaggerated.

Or it may be the gravest peril to befall
mankind.

We do not yet know.
• We shall learn more as time goes on.This
talk looks first at how gw could affect the
macroeconomy; second, at how
developing knowledge could affect it; third,
at specific monetary policy implications;
and some more general issues concerned

with green GDP.

What is the simplest way of modelling the
macroeconomics of climate change?
• Carbon emissions from burning fossil fuel
are the dominant (but not only) element in
gw
• Aggregate output is inhibited by them
• So make the rate of extraction of fossil
fuels a negative influence on the rate of
technical progress

We combine this idea with standard
ideas
• Hotelling’s rule, linking the rate of change
of the expected excess of margianl
revenue over marginal extraction cost,
adjusted for any tax, to the rate of return
on capital
• This holds as a portfolio equilibrium

condition for a risk neutral owner of fossil
fuel reserves

Also add
• A Cobb Douglas aggregate production
function depending on capital, labour and
inputs of energy
• Labour augmenting technical progress,
which decreases as the resource
extraction rate rises
• Given values for population growth and
the savings ratio, + perfect competition

This model, with some simplification,
generates an infinite horizon steady state
• GW reduces the SS real interest rate
• It also lowers the SS growth rate of real income
• And the rate of fossil fuel extraction also falls (a
crumb of comfort)
• The more serious the GW phenomenon, the

larger these 3 reductions
• (Warning: all these effects could be reversed if
GW increases rate of depreciation of capital, and
savings ratio is gross of depreciation)

If we discover that GW is more
(less) serious than we thought:
• And assuming rational expectations,
immediate repercussions include:
• Anticipation of a gradual asymptotic
reduction (rise) in real interest rates
towards their new level
• A sudden ujump (drop) in real oil prices,
required by Hotelling’s rule
• A sudden drop (rise) in current output.

And finally adjustment towards a
permanently lower (higher) growth rate.
• These results depend – plausibly perhaps
- on assuming dynamic efficiency (namely

that the capital share of income exceeds
the savings ratio, so the real interest rate
exceeds the growth rate).

Some further effects
• Unanticipated discovery of an inexpensive
and largely effective (costless and 100%
effective) method of capturing carbon will
reduce (remove) the adverse effect of
extarction on technical progress. Result:
higher real interest, and extraction, and
growth; short run, fall in oil price and boom
in output

And if expectations of such
discoveries in the future go up?
• We now anticipate these changes at that
future date, with (muted) current impact,
so oil prices fall somewhat now,
unfortunately increasing current harmful

fossil fuel extraction and exacerbating GW
until the new carbon sequestration
techniques can be applied

A similar result – a fall in oil prices
now
• Would follow if there were an
unanticipated discovery now of a new and
cheaper source of non-fossil fuel
technology
• Or an increase expectation now of this at
some future date
• So GW could get worse before it gets
better

Monetary Policy Implications?
• At first glance negligible, especially if we think
that long run equilibrium values of real variables
are independent of the level or growth rate of
nominal monetary aggregates

• Fiscal policy might lower the rate of extraction –
especially if ad valorem oil taxes have a
DECLINING trend
• But on reflection there are important monetary
policy implications

If GW lowers long run real interest
rates
• The neutral nominal rate associated with a
given inflation target will (very gradually)
come down.
• If there are changing patterns of
uncertainty about the extent and gravity
and speed of GW effects, expectations of
equilibrium long run real interest rates will
become more volatile

And that, from Hotelling, could cause violent
swings in real oil prices
• Compared with a nonGW world, headline

inflation would become relatively harder to
target than core (ex-oil) inflation;
• And nominal income targeting would
become easier than inflation targeting;
• And (equilibrium) real exchange rates
between oil importing and oil exporting
countries would move about more.

In the longer run
• Rapid GW could create the need for new
giant mega projects, eg damming the
Skagerrak and the Mediterranean, and
protecting valuable real estate and
population centres in the Pacific Rim.
These would tend to drive up the cost of
capital, temporarily
• Large migration flows could also ensue.

Lastly, Green GDP
• Technically a misnomer! But appropriate to

redefine depreciation to include depletion of
nature’s bounty, and apply an expenditure tax
widened to reflect this;
• Redefinition of depletable resource trade as a
capital account item on the balance of payments
• Externality-internalizing taxation? Yes – but may
be ineffective in levels in the case of stocks of
oil, coal and natural gas.

Terima kasih!