ProdukHukum BankIndonesia
MONETARY POLICY AND CLIMATE CHANGE: IS THERE A ROLE
FOR THE CENTRAL BANK?
Remarks by Hernán Lacunza
General Manager, Central Bank of Argentina
This session’s topic is one that is rarely discussed: concern for climate change is not
something that we normally ask of monetary policy. We central bankers already have
enough on our plate as it is, and there are several critical areas already with a lot of
discussion on what monetary policy should do and how –namely, financial stability, asset
prices, coping with the adjustment to global imbalances, and so on. This is even more so
in the case of developing economies, where there are quite a number of items on the
central banks’ checklist to be considered before even dreaming of any concern for climate
change –the full development and operation of the transmission channels of monetary
policy, how to deal with macroeconomic stability in environments where “traditional” tools
may not always be at hand, extending the scale and scope of financial services, to name
but a few. And yet, sooner or later central bankers will face the need to “do something”
about climate change, as the issue gets increasingly higher in policymakers’ agendas, and
–perhaps more importantly- its macroeconomic effects become ever more present –
including not only the direct and indirect effects of weather-related disruptions and
catastrophes, but also the cost and consequences of the policies implemented to deal
with them, as well as the responses and changes in the behavior of economic agents that
these processes may bring about.
In the face of mounting evidence of the importance of climate change for
macroeconomic policy (of which this conference itself is proof), there are at least two
questions for us to ask. Can and should central banks respond to climate change, aiming
at controlling it or mitigating its effects in any specific way? This is no easy topic at all, and
I think it would take a whole seminar only to start asking the right questions. Still, no
matter how we answer them, we can still ask: given that climate change is going on, how
will it impact on the macroeconomy and what is the best way for monetary policy to react
to it? My presentation today will try to cover both points, and I will conclude by pointing out
some specific considerations for developing countries.
SHOULD MONETARY POLICY AIM AT CONTROLLING CLIMATE CHANGE?
Let me touch upon a number of issues that, I believe, are good starting points to think
about the relation between monetary policy and climate change. The first one is whether
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climate change is cyclical or, rather, behaves like a trend. This distinction is part of our
“toolkit” when dealing with macroeconomic variables, and I think it is relevant to ask the
question for climate change as well. After all, our task as central bankers has to do with
the business cycle, and longer-term developments tend to be farther from our everyday
activities. In this respect, evidence appears to be mixed, and there is no full agreement
among scientists as to what is actually happening to the global climate. Phases of global
warming and cooling seem to have been an ordinary event throughout the geological
history of our planet. Our recent concern with global warming seems to stem from both
what appears to be an acceleration of this cycle, that is changing our ecological and
economic landscape in ways that we do not fully understand, and the fact that this
acceleration may be due to man-made causes. Recent estimates indicate that the rise in
world temperature may range from 1.4°C to 5.8°C by the end of this century1. The culprit?
“Greenhouse” gases, generated by economic activity, that “trap” the heat coming from the
sun and prevent it from dissipating back into space. All in all, even if climate change is
part of a cycle, its frequency makes it look more like something permanent, and its
acceleration due to man-made factors is dramatic enough for us to be worried.
Costs to economic activity are just as uncertain: global GDP may decrease, on
average, by up to 3 percentage points (p.p.) for every increase in temperature of 3°C; if
the warming is as high as 6°C, the earth’s GDP may be down by 9 p.p.2. But other
important economic damages are not considered in such estimations: nonmarket and
social costs, catastrophic events and the like. And recent research suggests that the risk
is for much higher costs than average estimates.
There is an analogy here with the risk management approach to monetary policy. We
are not quite sure about what is going on with the earth’s climate, as evidence appears
mixed and we have no single reliable model to depict the process. Still, taking into
account the risks that adverse consequences may take place with an intensity and on a
scale that could alter our environment forever, with significant economic costs3, together
with the relatively moderate effectiveness of the tools with which we can deal with this
problem (and our uncertainty about their ultimate effects), taking action in order to curb
the factors responsible for global warming seems to be the most appropriate alternative.
There are two opposing factors here at play: on the one hand, climate change does
not appear to be the kind of cyclical development that we are used to deal with, in terms of
frequency and comovement with other economic variables; on the other hand, the
consequences that can so far be detected are dire enough to draw our attention. If we
1
Intergovernmental Panel on Climate Change, United Nations (2001).
Estimates from Nordhaus and Boyer (2000).
3
See, for instance, IMF (2008), Stern et al(2007).
2
2
believe that climate change looks more like a trend, at least for the timeframe of monetary
policy this should call for limited action on our part. The tools we manage are more apt to
deal with transitory, cyclical phenomena, than with longer term ones. Let me be clear
about this: I think that climate change, as we face it today, moves more like a trend than
like a cycle and that, for that reason, is not something that monetary policy is ready to deal
with; but its impact could be so high that we cannot ignore it, even if, in the final analysis,
other areas of economic policy are the most suitable to confront the problem.
Having said that, we have evidence that monetary policy may influence, to some
extent, growth processes –or at least, that it may influence developments that extend
beyond what we consider a typical cycle. A number of papers have shown a link between
growth and monetary policy; by managing the trend toward nominal appreciation,
monetary policy may be able, to certain extent, to induce growth, particularly of the exportled variety. In many countries –and the Chinese and Indian experiences comes readily to
mind here- these growth episodes have been associated to industrial development, with
what it means in terms of gas emissions. If this is so, then monetary policy meets a new
trade off, between fostering growth and sustaining the environment. Should this be
addressed directly by central banks, or should it be left to other areas of economic policy?
If monetary policy is believed to contribute directly to growth, and growth is associated to
the emissions that cause the “greenhouse” effect, then part of those emissions could be
moderated by central banks’ actions. Some may argue this is not the right way to go: why
sacrifice growth in developing countries, while the bulk of greenhouse gases is still
produced by industrial economies?
Likewise, many countries today practice some form of explicit or implicit “flexible
inflation targeting”, which, together with inflation, aims at stabilizing some definition of the
output gap. The output gap component in this scheme could be “environmentally
adjusted” so that monetary policy decisions incorporate their impact on the environment
and, ultimately, on climate change. This may appear to be a very indirect channel, but
could be a manageable one for monetary policy –although at the cost of sacrificing
growth, instead of aiming at the most direct and technological causes of global warming.
This way, the kind of control or mitigation that monetary policy could perform does not
seem to be very efficient.
As many other have already argued, the balance in terms of effective response to
environmental challenges is tilted toward fiscal policy. Imposing taxes on or defining caps
to activities that generate the most harmful gas emissions seem the primary measure to
be taken in this respect. In addition, setting up markets where emissions can effectively be
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traded also seems a step in the right direction4. The idea is for productive activities to
internalize the costs generated by the emission of greenhouse gases (a similar scheme to
avoid deforestation could be thought of). Industrial policy, whose importance cannot be
underestimated in developing economies, can also help a great deal by favoring the
development of “greener” technologies. In the face of this, whatever monetary policy can
do seems fairly limited –after all, we are little more than the “liquid corner of public
finance”.
Summing up so far, climate change as we conceive it today does not seem to be the
kind of cyclical episode that monetary policy is more apt at dealing with; the way it could
handle emissions linked to higher economic activity (through monetary tightening) seems
too far from “fine tuning”. In this respect, fiscal and development policy appear to be better
suited to tackle climate change. That is why we now turn to the second question.
SHOULD MONETARY POLICY ADAPT TO CLIMATE CHANGE? AND HOW?
In order to assess what the likely macroeconomic impact of climate change is going to
be and to start thinking about the appropriate monetary policy to deal with its
consequences, we must first try to understand the nature of climate change as an
economic shock. I believe that the best way to think about climate change from the point
of view of a central banker is as a series of (real) autocorrelated negative supply shocks5.
Each of these negative supply shocks will likely lead to a contraction in the economy’s
productive capacity, generating higher prices and diminishing growth rates6; the more
persistent these shocks are, the higher are the chances that they lead to a permanent
reduction of potential output, affecting not only our economies’ cycles but also their
longer-term trends. It is natural to think of agriculture, forestry, fisheries, or tourism, as
some of the sectors most likely to be affected by changing weather conditions, but the
impact can actually be broader and extend to other sectors and, ultimately, to the whole
economy. Besides, climate change can have significant effects on trade, capital flows, and
migration, as well as on investment and savings.
Let me be more specific about these economic consequences. According to what we
hypothesize about climate change as a supply shock, it may reflect both an upward trend
in the frequency of weather-related disruptions, and an increase in their severity.
4
Still, to the extent that certain solutions involve setting up new markets, central banks could always act in
specific ways as “market makers” of financial instruments aimed at curbing gas emissions. For an example of
such instruments, see Fine et al (n/d).
5
Even though, of course it may clearly have an impact on aggregate demand as well.
6
Supply shocks due to climate change may be either negative or positive, depending on each region or
country; available estimates, however, suggest that their global effect is likely to be negative. See Nordhaus
(2000), Mendehlson et al. (2000).
4
Increased uncertainty, as a result of the rise in the variance of the “random component” of
natural phenomena, implies that economic agents and financial markets may react
through a rise in risk premia, with adverse effects on investment and economic growth;
typically, investment projects sensitive to weather conditions will require higher rates of
return to compensate for higher risk. In this regard, climate change reinforces the
argument that focuses on irreversibility as an important factor that can discourage
investment, since its effects can be so strong as to make large extensions of up-to-now
valuable territory totally worthless. In addition, climate change may alter economic agents´
behavior broadly, affecting the propensity to consume, while policy responses generate
changes in taxation and emission controls that are also hard to predict with accuracy.
More frequent and volatile real shocks are likely to generate higher inflation volatility,
no matter how much the central bank attempts to moderate it. Given that weather-related
shocks are largely unpredictable and most often transitory, monetary policy does not have
appropriate or reliable instruments to reduce short-run volatility. To make matters worse,
the central bank would need to have an amount and quality of information about
“developments on the ground” that it may not be easy to gather quickly enough. Thus,
there may be a higher variability of output and inflation in the future without implying that
monetary policy has been suboptimal. Even if monetary policy becomes more “efficient”,
climate change may lead to worse overall economic outcomes.
The challenges that lie ahead of us would not be so daunting were it not for the
difficulties due to a process related to climate change: excess demand for natural
resources at the global level and the consequent increase in the relative prices of
commodities. It may be argued that this change in relative prices is not, strictly speaking,
inflation; however, if the horizon over which relative prices finally stabilize is far into the
future, it may be wrong for the central bank not to consider the increase in commodity
prices as “genuine inflation”.
What are the implications of climate change for monetary policy in this complex
scenario? Should we reassess the current “standard” in monetary policy formulation in the
light of these developments? The easy part of the answer is that there is no reason why
climate change, or the increase in the relative price of commodities, should lead to a
change in the objectives of monetary policy. The lessons we have learnt in recent
decades suggest that we should stick to the fundamental role of central banks: preserving
price stability from an intertemporal perspective and, to the extent that it is possible,
contribute to short-term output stabilization.
However, just as recent events in financial markets have put to test many of the
conventional notions on central banking, the combination of adverse weather shocks and
an upward trend in the prices of food, energy and other raw materials may call for a
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somewhat different “reaction function” of central banks. Conventional wisdom assumes
that the proper policy response to negative supply shocks is to simply “ignore” them –
given that they are transitory or have very low persistence, and that they do not affect all
sectors alike-, and try to avoid second-round effects that may increase inflation
expectations. This “optimal” response implies, in most cases, the need to accept some
temporary rise in inflation and, possibly, unemployment. However, this recipe involves the
implicit assumption that the policymaker can clearly identify both the nature of the shocks
impinging on the economy and their impact; in practice, the policy response is not so
mechanic, given the need to assess the specific implications of each shock. But the
principle remains that reacting to temporary fluctuations in relative prices induced by this
kind of shocks will tend to boost instability, the opposite of what central banks aim at.
The current scenario the world appears to be facing does not fit all that well into this
picture: we may be witnessing the emergence of a “persistent major negative supply
shock”. So it is far from obvious that central banks should pursue a policy of zero
accommodation. Quite on the contrary, this may call for a considerable degree of
accommodation, as long as authorities want to prevent the economy from sliding into an
avoidable recession as a result of the need to push (real) interest rates beyond the range
that the economy can withstand. This is especially relevant if the public has difficulties in
realizing or accepting the decrease in living standards that these phenomena are likely to
imply. If this fact is not understood by society, and politics does not contribute to
explaining the implications to the public, real-wage resistance may complicate monetary
policy.
In addition, a continued rise in the relative prices of food, energy and other raw
materials will push up inflation expectations and market interest rates given the likely rise
in the inflation risk-premium. Of course, in an ideal world central bankers would prefer to
stay firm and watch other (non-commodity) prices fall so that relative prices adjust; in
practice, if the disruption is too strong, that is not the course that will be followed.
What does this mean in terms of what we call today inflation targets? Climate change
and the scarcity of commodities at the global level may require certain flexibilization of
those targets. This should not be taken as meaning that monetary policy should adopt a
stance of full accommodation to supply shocks; rather, central bankers will need to assess
the nature of each supply shock episode to determine its degree of “persistence” and
thus, whether to accommodate or not and the extent of that accommodation. The central
bank has obviously no chance of counteracting a change in relative prices (in the long
run), but it can hopefully prevent strong disruptions from generating excessive economic
damage by making well-balanced interest rate decisions.
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This certainly brings to mind what central bankers have practiced for a long time, and
is increasingly becoming articulated in their speeches and papers: the risk management
approach to monetary policy. It is precisely this kind of episode that calls for a very fine
balance between models and judgment: given that we are very uncertain about the
magnitude, timing, and effects of the shocks we may face out of climate change, we
cannot rest on a single model (or set of them), and at the same time we have to carefully
evaluate the probabilities associated to each scenario we foresee, how effective are the
tools that we count on to deal with them, and what are its economic consequences –a
scenario that may not be very probable, but that has very high costs and for which we
have relatively “weak” tools, is one that merits attention. Only from this combination of
data analysis, models and judgment we can reach satisfactory decisions in the face of
uncertainty.
To talk about risk management and the basic principles that central banks could follow
in an environment of climate change may be too general: let me touch on a number of
particular issues that I believe will be of increasing importance7.
INFLATION EXPECTATIONS
Probably one of the most difficult tasks will be the “management” of the public’s
expectations of inflation. Current theory and practice emphasizes the need to build
credibility and improve communication and transparency, focusing on the desirable impact
these have on market expectations and those of the public at large. But these pillars may
become more difficult to implement in a world subject to a level of “background noise” to
which economic agents are unaccustomed. Rapid price rises will likely deteriorate inflation
expectations regardless of whether the policymakers’ response is optimal or not. There is
a limit to what can be explained to the public and there is also a limit to what the public will
believe. This does not mean that the credibility and transparency are useless. On the
contrary, I think we are all advocates of them, but the new scenario somewhat diminishes
their power and this means that the convergence of market expectations and the central
bank targets could be more difficult to achieve (but more on this later).
CHOICE OF INFLATION TARGET
In the face of climate change, should central banks focus on core inflation instead of
headline inflation? If this problem translates into changes in relative prices of a structural
7
These points draw partly on Liikanen (2008).
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nature, the usual practice of constructing the index of core inflation becomes less useful, if
not incorrect: changes in prices of energy and other emission-intensive goods would not
be random and transitory, but rather a systematic component of CPI increases, and there
would be an increasing gap between headline and core inflation. As long as central banks
are guided by core inflation, food or energy supply shocks would basically generate no
policy response; the usual argument for ignoring changes in food and energy prices is that
although these have substantial effects on the overall index, they often are quickly
reversed –but these could not be the case in the foreseeable future. As a result, these
shocks would be passed through into a higher price level, since there is no mechanism to
drive other prices down when food or energy costs rise. This sounds familiar in terms of
recent experience. Current evidence from the us shows that consumer-price inflation
originating in food and energy may be “diffusing” to non-food-and-energy CPI
components: the latest data show a year-on-year 5% rise in headline inflation vis-à-vis a
2.4% increase in Core CPI. If the usual 2% to 3% explicit or implicit target for inflation that
many central banks set nowadays is not changed, many prices will even have to drop in
absolute terms for a considerable period. Otherwise, we should be ready to let prices rise
from current targets –as, for instance, is already happening in a number of Latin American
countries.
What is more, recent research shows that changes in food and gasoline prices
influence more the public’s perception of inflation than changes in the prices of less
frequently buyed products and services. Besides, the fact that price rises leave a much
stronger “imprint” in people’s minds than price drops generates an upward bias in inflation
expectations. Thus, a higher frequency (and more extreme “amplitude”) of adverse
weather shocks may lead those expectations to remain above “true” CPI headline inflation
for a long time, opening a gap between measured and perceived inflation, and making it
difficult for the central bank to reduce inflation without imposing heavy costs in terms of
output and employment. In this context, a central bank that has both inflation and the
output gap as its objectives will tend to be more “accommodating” in its monetary policy
than in a world where the frequency of supply shocks is lower. To improve the nature of
this trade-off, and prevent the impact of relative price changes from generating a wageprice spiral, or so-called second-round effects, credibility is perhaps more essential than
ever.
An example here is in point: the Reserve Bank of New Zealand, in its monetary policy
statement of the 4th quarter of 2007, analyzes the impact on prices for New Zealand of a
new emissions trading scheme, established by the Kyoto protocol. The new regulation
prices of electricity and fuel are expected to increase, and the RBNZ has published the
estimates of the first-round price effects on CPI for 2009 and 2010. The RBNZ clearly
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states that they will not react to the first-round price effects. However, if they affect the
medium-term path of inflation, policy actions will be necessary. How the matter will evolve
is certainly open -this is just an example of how this matter makes communication more
sophisticated, and makes central banks much more attentive to discrimination between
“core” and headline measures.
CHOICE OF FOREIGN EXCHANGE REGIME
Standard arguments suggest that exchange rate flexibility makes it easier for the
economy to adjust to real shocks. In the face of negative consequences of climate change
(windstorms, long-lasting draughts, floods), depreciation of the domestic currency can
increase the domestic price of exports, helping to offset the effects of the adverse shock.
Even more important than the direct impact on imports and exports is the fact that a
flexible exchange rate gives the monetary authority degrees of freedom to compensate
the effects of the shock via the interest rate policy. Thus, climate change and the rise in
the relative prices of commodities (and their volatility) will make fixed exchange regimes
increasingly unfeasible, and consolidate the preference for relatively flexible exchange
rate arrangements. Indeed, the multiplicity of shocks that will hit the system requires that
monetary policy be free from the constraints of a rigid peg. Besides, if for some reason a
shock originating abroad leads to a faster rise in prices in the rest of the world than at the
domestic level, a monetary policy that is not committed to defending a peg will also
contribute to limiting the impact on domestic prices.
This is not to imply that purely floating regimes will be the norm. They may have
important drawbacks when significant currency mismatches, high pass through to
domestic prices, or an important role of the foreign exchange in inflation expectations are
present. Managed floating should be preferred in this cases, as shown by the experience
of many developing economies (including inflation targeters8). Such experiences also
show that international reserves’ accumulation is an important prudential instrument to
deal with external shocks9; this is more so if climate change increases the volatility of
commodity prices and the occurrence of such shocks.
FINANCIAL STABILITY
Recent events have brought to the forefront the importance of financial regulation, at
the risk of facing adverse consequences in the real economy. Climate change adds a new
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9
See Chang (2008).
See Redrado et al (2006).
9
item to the list of risks that banks have to learn to manage –namely, climate risk. Credit
risk evaluation will have to factor in the presence of unprecedented shocks to projected
loans, and banks will also have to make further provisions to their loan portfolio. Besides,
the emergence of markets for trading emission quotas is yet another challenging addition
to the complexity of financial markets; certainly, regulators will have to focus on the
specific financial and legal risks faced by participants in those markets.
MODELLING AND FORECASTING
Macroeconomic forecasting and modelling also become more complicated as a result
of climate change and the rising relative prices of commodities. The complexities poised
by these phenomena reduce the accuracy of the forecasts generated by models. The
estimation of the output gap, for instance, becomes more difficult. We may be able to
ascertain that the rate of growth in potential output will fall but probably not by how much.
Sudden bottlenecks provoked by adverse weather shocks may rapidly turn a situation of
excess supply in certain sectors into one of excess demand. And forecasting future prices
of commodities or natural resources, which is likely to be more important than ever, will be
more difficult. The poor forecasting power of commodity futures markets gives little ground
for optimism regarding this.
The practical consequences for monetary policy may be dire: it is common to model
the behavior of central banks as a rule that complies with price stability while stabilizing
the GDP around its potential level. If negative and persistent effects of global warming are
not appropriately taken into account in the potential GDP measure, a decrease in actual
GDP generated by a supply shock can be interpreted as a positive output gap and thus
will lead to an expansionary monetary policy, which then could be reflected in an
unnecessarily high inflation rate in the short term.
The phenomena we are discussing imply a dramatic change in the structure of the
economy and they may even lead to a change in the relative force of the different
channels of the transmission process, adding to the usual uncertainties surrounding the
“long and variable lags” of monetary policy. Thus, it is hard to believe that estimations
performed over a very different sample period could perform well under the new realities.
It is likely that monetary policy will have to rely even more heavily than in recent years on
judgment –bringing us back to the relevance of risk management, something that we
know first hand in developing countries.
A VIEW FROM THE DEVELOPING WORLD
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The kinds of problems I have discussed so far are fairly familiar to central bankers in
emerging market countries. Unexpected supply shocks (out of changing weather
conditions, trade disruptions, new technologies, and so on), sudden changes in financial
market sentiment, the difficulty to reap the benefits of foreign exchange flexibility when
there is financial dollarization and high pass through, are all part of our everyday
concerns. This has led us to develop a number of strategies that differ to a considerable
extent from the standard “inflation targeting cum floating exchange rates” view, not in its
aims (macroeconomic stability) but in its operation. And we also know from direct
experience how coordination among policy makers can substantially improve outcomes –
and how its lack leads to very suboptimal results, to put it mildly. Let me mention a few of
these points.
ACCUMULATION OF INTERNATIONAL RESERVES
As a form of insurance against external shocks, this has been, I would say, the
common pattern all across the emerging world in recent years. Today, with no
international lender of last resort, there is no good substitute for sound external liquidity
policy at the country level. I am afraid it is the responsibility of every country to develop its
own set of countercyclical policies that would help offset limited access to financial
markets, without having a significant impact on domestic variables. Building a
precautionary cushion of foreign reserves is particularly important for emerging countries,
where there is a tighter connection between monetary, fiscal and financial stability. There
are also very successful examples of stabilization funds associated to commodity exports
that serve the same purpose. The latter could indeed be a model for the kind of actions
that could help us be better prepared for unexpected changes in weather conditions that
affect directly the production of commodities.
MANAGED FLOATING
A managed floating exchange rate regime enables us to weather situations of
economic or financial stress without leading to unwarranted changes in expectations and
financial disruption. We do not want to prevent variables from converging to their longterm values, but we would rather avoid excessive volatility as a source of unnecessary
disturbances in economic decisions. On the other hand, we do not want to provide any
sort of insurance that favors speculative flows –in short, a regime that, without providing
any sort of “foreign exchange insurance,” prevents excessive volatility from affecting
economic decisions. The benefits of this kind of policies are well-known. Empirical studies
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find that even reaction functions of inflation targeting central banks in emerging countries
have a significant coefficient for the nominal exchange rate. And recent theoretical works
include segmentation and restricted access to financial markets into the analysis of
foreign exchange policy; the most relevant conclusions suggest that, in terms of
maximizing social welfare, the best choice is a less flexible foreign exchange regime
where access to hedging instruments is more limited. And this is a more realistic
conceptual framework for economies like ours.
FOSTERING POLICY COORDINATION
Our countries need an efficient (and effective) way of handling risks associated to the
reversal of currently benign conditions. Take, for instance, the strategy of accumulating
reserves; it certainly is an effective way of gaining liquid assets that may be used to
counter external shocks as the ones I have discussed; but it may not be the most efficient
solution, as a (supranational) pool of reserves may do the same job without requiring the
same individual effort from each country. There is a role for coordination here, perhaps
fostered by international financial institutions, in improving “risk management”. Needless
to say, when it comes to the question of the factors that underlie climate change,
coordination will be essential in trying to mitigate it through lower emissions. But problems
of collective action also arise when it comes to the choice of macroeconomic policies
aimed at responding to climate change. As shocks related to it may occur either at a
national or an international level, policies that focus only on individual countries may be
highly inefficient, even counterproductive –in the same way as “beggar-thy-neighbor”
policies are counterproductive for trade. Thus, coordination at an international level is of
the essence. This is certainly easier said than done, as different initiatives have shown so
far; still, the risks that we face are high enough as to force us to insist on the need for
coordination.
Let me sum up on what, I believe, are the main points of this discussion. However
uncertain the developments on climate change may be, the risks they entail are so high
that they deserve careful attention from economic policy. When it comes to central
banking, it does not appear that monetary policy by itself can do a particularly efficient job
of controlling or mitigating the factors that lead to climate change, a role for which fiscal
and industrial policy are better suited for. Instead, monetary policy can devote efforts to
adapt to climate change so that its contribution to macroeconomic stability is not
jeopardized. As climate change involves a more uncertain environment, a risk
management approach is the best way, in my view, to tackle the problem; in particular, the
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standard inflation targeting approach should be modified in order to deal with persistent
supply shocks –through the use of countercyclical policies as reserve accumulation,
exchange rate management, and perhaps a more extensive use of informed judgment
than before. The bright side is that all this is by no means new to developing countries’
central banks, a number of tools that we have used over the years may serve to deal with
these new realities –by sharing our experience in this area, we may make a lasting
contribution to global macroeconomic stability. Thank you.
REFERENCES
-Chang, Roberto (2008): “Inflation Targeting, Reserves Accumulation, and Exchange Rate
Management in Latin America”, Borradores de Economía, Banco Central de Colombia, N°
487, 2008.
-Fine, Ben, Oliver Madison, Emily Paddon, Andrew Sniderman and Tom Rand (N/D):
“Green Bonds: A Public Policy Proposal”, Action Canada, Mimeo.
-IMF (2008) Chapter 4: “Climate Change and The Global Economy”, World Economic
Outlook, April; Prepared By Natalia Tamirisa, Florence Jaumotte, Ben Jones, Paul Mills,
Rodney Ramcharan, Alasdair Scott, and Jon Strand
-Liikanen, Erkki (2008): “Climate Change and Its Implications for Central Banks”, HighLevel Seminar of the EMEAP and the Euro Area Banca d'Italia, Rome, 27 June.
-Mendelsohn, Robert, Michael Schlesinger, and Larry Williams (2000) “Comparing
Impacts Across Climate Models,” Integrated Assessment, Vol. 1 (March)
-Nordhaus, William and Joseph Boyer (2000), Warming the World: Economic Models of
Global Warming (Cambridge, Massachusetts: MIT Press).
-Redrado, Martin, Jorge Carrera, Diego Bastourre and Javier Ibarlucia (2006): “The
Economic Policy of Foreign Reserve Accumulation: New International Evidence” BCRA
Paper Series | 2, Central Bank of Argentina, November.
-Reserve Bank of New Zealand (2007): “Monetary Policy Statement”, December.
-Stern, Nicholas, and Others (2007): The Economics of Climate Change: The Stern
Review (London: HM Treasury).
13
FOR THE CENTRAL BANK?
Remarks by Hernán Lacunza
General Manager, Central Bank of Argentina
This session’s topic is one that is rarely discussed: concern for climate change is not
something that we normally ask of monetary policy. We central bankers already have
enough on our plate as it is, and there are several critical areas already with a lot of
discussion on what monetary policy should do and how –namely, financial stability, asset
prices, coping with the adjustment to global imbalances, and so on. This is even more so
in the case of developing economies, where there are quite a number of items on the
central banks’ checklist to be considered before even dreaming of any concern for climate
change –the full development and operation of the transmission channels of monetary
policy, how to deal with macroeconomic stability in environments where “traditional” tools
may not always be at hand, extending the scale and scope of financial services, to name
but a few. And yet, sooner or later central bankers will face the need to “do something”
about climate change, as the issue gets increasingly higher in policymakers’ agendas, and
–perhaps more importantly- its macroeconomic effects become ever more present –
including not only the direct and indirect effects of weather-related disruptions and
catastrophes, but also the cost and consequences of the policies implemented to deal
with them, as well as the responses and changes in the behavior of economic agents that
these processes may bring about.
In the face of mounting evidence of the importance of climate change for
macroeconomic policy (of which this conference itself is proof), there are at least two
questions for us to ask. Can and should central banks respond to climate change, aiming
at controlling it or mitigating its effects in any specific way? This is no easy topic at all, and
I think it would take a whole seminar only to start asking the right questions. Still, no
matter how we answer them, we can still ask: given that climate change is going on, how
will it impact on the macroeconomy and what is the best way for monetary policy to react
to it? My presentation today will try to cover both points, and I will conclude by pointing out
some specific considerations for developing countries.
SHOULD MONETARY POLICY AIM AT CONTROLLING CLIMATE CHANGE?
Let me touch upon a number of issues that, I believe, are good starting points to think
about the relation between monetary policy and climate change. The first one is whether
1
climate change is cyclical or, rather, behaves like a trend. This distinction is part of our
“toolkit” when dealing with macroeconomic variables, and I think it is relevant to ask the
question for climate change as well. After all, our task as central bankers has to do with
the business cycle, and longer-term developments tend to be farther from our everyday
activities. In this respect, evidence appears to be mixed, and there is no full agreement
among scientists as to what is actually happening to the global climate. Phases of global
warming and cooling seem to have been an ordinary event throughout the geological
history of our planet. Our recent concern with global warming seems to stem from both
what appears to be an acceleration of this cycle, that is changing our ecological and
economic landscape in ways that we do not fully understand, and the fact that this
acceleration may be due to man-made causes. Recent estimates indicate that the rise in
world temperature may range from 1.4°C to 5.8°C by the end of this century1. The culprit?
“Greenhouse” gases, generated by economic activity, that “trap” the heat coming from the
sun and prevent it from dissipating back into space. All in all, even if climate change is
part of a cycle, its frequency makes it look more like something permanent, and its
acceleration due to man-made factors is dramatic enough for us to be worried.
Costs to economic activity are just as uncertain: global GDP may decrease, on
average, by up to 3 percentage points (p.p.) for every increase in temperature of 3°C; if
the warming is as high as 6°C, the earth’s GDP may be down by 9 p.p.2. But other
important economic damages are not considered in such estimations: nonmarket and
social costs, catastrophic events and the like. And recent research suggests that the risk
is for much higher costs than average estimates.
There is an analogy here with the risk management approach to monetary policy. We
are not quite sure about what is going on with the earth’s climate, as evidence appears
mixed and we have no single reliable model to depict the process. Still, taking into
account the risks that adverse consequences may take place with an intensity and on a
scale that could alter our environment forever, with significant economic costs3, together
with the relatively moderate effectiveness of the tools with which we can deal with this
problem (and our uncertainty about their ultimate effects), taking action in order to curb
the factors responsible for global warming seems to be the most appropriate alternative.
There are two opposing factors here at play: on the one hand, climate change does
not appear to be the kind of cyclical development that we are used to deal with, in terms of
frequency and comovement with other economic variables; on the other hand, the
consequences that can so far be detected are dire enough to draw our attention. If we
1
Intergovernmental Panel on Climate Change, United Nations (2001).
Estimates from Nordhaus and Boyer (2000).
3
See, for instance, IMF (2008), Stern et al(2007).
2
2
believe that climate change looks more like a trend, at least for the timeframe of monetary
policy this should call for limited action on our part. The tools we manage are more apt to
deal with transitory, cyclical phenomena, than with longer term ones. Let me be clear
about this: I think that climate change, as we face it today, moves more like a trend than
like a cycle and that, for that reason, is not something that monetary policy is ready to deal
with; but its impact could be so high that we cannot ignore it, even if, in the final analysis,
other areas of economic policy are the most suitable to confront the problem.
Having said that, we have evidence that monetary policy may influence, to some
extent, growth processes –or at least, that it may influence developments that extend
beyond what we consider a typical cycle. A number of papers have shown a link between
growth and monetary policy; by managing the trend toward nominal appreciation,
monetary policy may be able, to certain extent, to induce growth, particularly of the exportled variety. In many countries –and the Chinese and Indian experiences comes readily to
mind here- these growth episodes have been associated to industrial development, with
what it means in terms of gas emissions. If this is so, then monetary policy meets a new
trade off, between fostering growth and sustaining the environment. Should this be
addressed directly by central banks, or should it be left to other areas of economic policy?
If monetary policy is believed to contribute directly to growth, and growth is associated to
the emissions that cause the “greenhouse” effect, then part of those emissions could be
moderated by central banks’ actions. Some may argue this is not the right way to go: why
sacrifice growth in developing countries, while the bulk of greenhouse gases is still
produced by industrial economies?
Likewise, many countries today practice some form of explicit or implicit “flexible
inflation targeting”, which, together with inflation, aims at stabilizing some definition of the
output gap. The output gap component in this scheme could be “environmentally
adjusted” so that monetary policy decisions incorporate their impact on the environment
and, ultimately, on climate change. This may appear to be a very indirect channel, but
could be a manageable one for monetary policy –although at the cost of sacrificing
growth, instead of aiming at the most direct and technological causes of global warming.
This way, the kind of control or mitigation that monetary policy could perform does not
seem to be very efficient.
As many other have already argued, the balance in terms of effective response to
environmental challenges is tilted toward fiscal policy. Imposing taxes on or defining caps
to activities that generate the most harmful gas emissions seem the primary measure to
be taken in this respect. In addition, setting up markets where emissions can effectively be
3
traded also seems a step in the right direction4. The idea is for productive activities to
internalize the costs generated by the emission of greenhouse gases (a similar scheme to
avoid deforestation could be thought of). Industrial policy, whose importance cannot be
underestimated in developing economies, can also help a great deal by favoring the
development of “greener” technologies. In the face of this, whatever monetary policy can
do seems fairly limited –after all, we are little more than the “liquid corner of public
finance”.
Summing up so far, climate change as we conceive it today does not seem to be the
kind of cyclical episode that monetary policy is more apt at dealing with; the way it could
handle emissions linked to higher economic activity (through monetary tightening) seems
too far from “fine tuning”. In this respect, fiscal and development policy appear to be better
suited to tackle climate change. That is why we now turn to the second question.
SHOULD MONETARY POLICY ADAPT TO CLIMATE CHANGE? AND HOW?
In order to assess what the likely macroeconomic impact of climate change is going to
be and to start thinking about the appropriate monetary policy to deal with its
consequences, we must first try to understand the nature of climate change as an
economic shock. I believe that the best way to think about climate change from the point
of view of a central banker is as a series of (real) autocorrelated negative supply shocks5.
Each of these negative supply shocks will likely lead to a contraction in the economy’s
productive capacity, generating higher prices and diminishing growth rates6; the more
persistent these shocks are, the higher are the chances that they lead to a permanent
reduction of potential output, affecting not only our economies’ cycles but also their
longer-term trends. It is natural to think of agriculture, forestry, fisheries, or tourism, as
some of the sectors most likely to be affected by changing weather conditions, but the
impact can actually be broader and extend to other sectors and, ultimately, to the whole
economy. Besides, climate change can have significant effects on trade, capital flows, and
migration, as well as on investment and savings.
Let me be more specific about these economic consequences. According to what we
hypothesize about climate change as a supply shock, it may reflect both an upward trend
in the frequency of weather-related disruptions, and an increase in their severity.
4
Still, to the extent that certain solutions involve setting up new markets, central banks could always act in
specific ways as “market makers” of financial instruments aimed at curbing gas emissions. For an example of
such instruments, see Fine et al (n/d).
5
Even though, of course it may clearly have an impact on aggregate demand as well.
6
Supply shocks due to climate change may be either negative or positive, depending on each region or
country; available estimates, however, suggest that their global effect is likely to be negative. See Nordhaus
(2000), Mendehlson et al. (2000).
4
Increased uncertainty, as a result of the rise in the variance of the “random component” of
natural phenomena, implies that economic agents and financial markets may react
through a rise in risk premia, with adverse effects on investment and economic growth;
typically, investment projects sensitive to weather conditions will require higher rates of
return to compensate for higher risk. In this regard, climate change reinforces the
argument that focuses on irreversibility as an important factor that can discourage
investment, since its effects can be so strong as to make large extensions of up-to-now
valuable territory totally worthless. In addition, climate change may alter economic agents´
behavior broadly, affecting the propensity to consume, while policy responses generate
changes in taxation and emission controls that are also hard to predict with accuracy.
More frequent and volatile real shocks are likely to generate higher inflation volatility,
no matter how much the central bank attempts to moderate it. Given that weather-related
shocks are largely unpredictable and most often transitory, monetary policy does not have
appropriate or reliable instruments to reduce short-run volatility. To make matters worse,
the central bank would need to have an amount and quality of information about
“developments on the ground” that it may not be easy to gather quickly enough. Thus,
there may be a higher variability of output and inflation in the future without implying that
monetary policy has been suboptimal. Even if monetary policy becomes more “efficient”,
climate change may lead to worse overall economic outcomes.
The challenges that lie ahead of us would not be so daunting were it not for the
difficulties due to a process related to climate change: excess demand for natural
resources at the global level and the consequent increase in the relative prices of
commodities. It may be argued that this change in relative prices is not, strictly speaking,
inflation; however, if the horizon over which relative prices finally stabilize is far into the
future, it may be wrong for the central bank not to consider the increase in commodity
prices as “genuine inflation”.
What are the implications of climate change for monetary policy in this complex
scenario? Should we reassess the current “standard” in monetary policy formulation in the
light of these developments? The easy part of the answer is that there is no reason why
climate change, or the increase in the relative price of commodities, should lead to a
change in the objectives of monetary policy. The lessons we have learnt in recent
decades suggest that we should stick to the fundamental role of central banks: preserving
price stability from an intertemporal perspective and, to the extent that it is possible,
contribute to short-term output stabilization.
However, just as recent events in financial markets have put to test many of the
conventional notions on central banking, the combination of adverse weather shocks and
an upward trend in the prices of food, energy and other raw materials may call for a
5
somewhat different “reaction function” of central banks. Conventional wisdom assumes
that the proper policy response to negative supply shocks is to simply “ignore” them –
given that they are transitory or have very low persistence, and that they do not affect all
sectors alike-, and try to avoid second-round effects that may increase inflation
expectations. This “optimal” response implies, in most cases, the need to accept some
temporary rise in inflation and, possibly, unemployment. However, this recipe involves the
implicit assumption that the policymaker can clearly identify both the nature of the shocks
impinging on the economy and their impact; in practice, the policy response is not so
mechanic, given the need to assess the specific implications of each shock. But the
principle remains that reacting to temporary fluctuations in relative prices induced by this
kind of shocks will tend to boost instability, the opposite of what central banks aim at.
The current scenario the world appears to be facing does not fit all that well into this
picture: we may be witnessing the emergence of a “persistent major negative supply
shock”. So it is far from obvious that central banks should pursue a policy of zero
accommodation. Quite on the contrary, this may call for a considerable degree of
accommodation, as long as authorities want to prevent the economy from sliding into an
avoidable recession as a result of the need to push (real) interest rates beyond the range
that the economy can withstand. This is especially relevant if the public has difficulties in
realizing or accepting the decrease in living standards that these phenomena are likely to
imply. If this fact is not understood by society, and politics does not contribute to
explaining the implications to the public, real-wage resistance may complicate monetary
policy.
In addition, a continued rise in the relative prices of food, energy and other raw
materials will push up inflation expectations and market interest rates given the likely rise
in the inflation risk-premium. Of course, in an ideal world central bankers would prefer to
stay firm and watch other (non-commodity) prices fall so that relative prices adjust; in
practice, if the disruption is too strong, that is not the course that will be followed.
What does this mean in terms of what we call today inflation targets? Climate change
and the scarcity of commodities at the global level may require certain flexibilization of
those targets. This should not be taken as meaning that monetary policy should adopt a
stance of full accommodation to supply shocks; rather, central bankers will need to assess
the nature of each supply shock episode to determine its degree of “persistence” and
thus, whether to accommodate or not and the extent of that accommodation. The central
bank has obviously no chance of counteracting a change in relative prices (in the long
run), but it can hopefully prevent strong disruptions from generating excessive economic
damage by making well-balanced interest rate decisions.
6
This certainly brings to mind what central bankers have practiced for a long time, and
is increasingly becoming articulated in their speeches and papers: the risk management
approach to monetary policy. It is precisely this kind of episode that calls for a very fine
balance between models and judgment: given that we are very uncertain about the
magnitude, timing, and effects of the shocks we may face out of climate change, we
cannot rest on a single model (or set of them), and at the same time we have to carefully
evaluate the probabilities associated to each scenario we foresee, how effective are the
tools that we count on to deal with them, and what are its economic consequences –a
scenario that may not be very probable, but that has very high costs and for which we
have relatively “weak” tools, is one that merits attention. Only from this combination of
data analysis, models and judgment we can reach satisfactory decisions in the face of
uncertainty.
To talk about risk management and the basic principles that central banks could follow
in an environment of climate change may be too general: let me touch on a number of
particular issues that I believe will be of increasing importance7.
INFLATION EXPECTATIONS
Probably one of the most difficult tasks will be the “management” of the public’s
expectations of inflation. Current theory and practice emphasizes the need to build
credibility and improve communication and transparency, focusing on the desirable impact
these have on market expectations and those of the public at large. But these pillars may
become more difficult to implement in a world subject to a level of “background noise” to
which economic agents are unaccustomed. Rapid price rises will likely deteriorate inflation
expectations regardless of whether the policymakers’ response is optimal or not. There is
a limit to what can be explained to the public and there is also a limit to what the public will
believe. This does not mean that the credibility and transparency are useless. On the
contrary, I think we are all advocates of them, but the new scenario somewhat diminishes
their power and this means that the convergence of market expectations and the central
bank targets could be more difficult to achieve (but more on this later).
CHOICE OF INFLATION TARGET
In the face of climate change, should central banks focus on core inflation instead of
headline inflation? If this problem translates into changes in relative prices of a structural
7
These points draw partly on Liikanen (2008).
7
nature, the usual practice of constructing the index of core inflation becomes less useful, if
not incorrect: changes in prices of energy and other emission-intensive goods would not
be random and transitory, but rather a systematic component of CPI increases, and there
would be an increasing gap between headline and core inflation. As long as central banks
are guided by core inflation, food or energy supply shocks would basically generate no
policy response; the usual argument for ignoring changes in food and energy prices is that
although these have substantial effects on the overall index, they often are quickly
reversed –but these could not be the case in the foreseeable future. As a result, these
shocks would be passed through into a higher price level, since there is no mechanism to
drive other prices down when food or energy costs rise. This sounds familiar in terms of
recent experience. Current evidence from the us shows that consumer-price inflation
originating in food and energy may be “diffusing” to non-food-and-energy CPI
components: the latest data show a year-on-year 5% rise in headline inflation vis-à-vis a
2.4% increase in Core CPI. If the usual 2% to 3% explicit or implicit target for inflation that
many central banks set nowadays is not changed, many prices will even have to drop in
absolute terms for a considerable period. Otherwise, we should be ready to let prices rise
from current targets –as, for instance, is already happening in a number of Latin American
countries.
What is more, recent research shows that changes in food and gasoline prices
influence more the public’s perception of inflation than changes in the prices of less
frequently buyed products and services. Besides, the fact that price rises leave a much
stronger “imprint” in people’s minds than price drops generates an upward bias in inflation
expectations. Thus, a higher frequency (and more extreme “amplitude”) of adverse
weather shocks may lead those expectations to remain above “true” CPI headline inflation
for a long time, opening a gap between measured and perceived inflation, and making it
difficult for the central bank to reduce inflation without imposing heavy costs in terms of
output and employment. In this context, a central bank that has both inflation and the
output gap as its objectives will tend to be more “accommodating” in its monetary policy
than in a world where the frequency of supply shocks is lower. To improve the nature of
this trade-off, and prevent the impact of relative price changes from generating a wageprice spiral, or so-called second-round effects, credibility is perhaps more essential than
ever.
An example here is in point: the Reserve Bank of New Zealand, in its monetary policy
statement of the 4th quarter of 2007, analyzes the impact on prices for New Zealand of a
new emissions trading scheme, established by the Kyoto protocol. The new regulation
prices of electricity and fuel are expected to increase, and the RBNZ has published the
estimates of the first-round price effects on CPI for 2009 and 2010. The RBNZ clearly
8
states that they will not react to the first-round price effects. However, if they affect the
medium-term path of inflation, policy actions will be necessary. How the matter will evolve
is certainly open -this is just an example of how this matter makes communication more
sophisticated, and makes central banks much more attentive to discrimination between
“core” and headline measures.
CHOICE OF FOREIGN EXCHANGE REGIME
Standard arguments suggest that exchange rate flexibility makes it easier for the
economy to adjust to real shocks. In the face of negative consequences of climate change
(windstorms, long-lasting draughts, floods), depreciation of the domestic currency can
increase the domestic price of exports, helping to offset the effects of the adverse shock.
Even more important than the direct impact on imports and exports is the fact that a
flexible exchange rate gives the monetary authority degrees of freedom to compensate
the effects of the shock via the interest rate policy. Thus, climate change and the rise in
the relative prices of commodities (and their volatility) will make fixed exchange regimes
increasingly unfeasible, and consolidate the preference for relatively flexible exchange
rate arrangements. Indeed, the multiplicity of shocks that will hit the system requires that
monetary policy be free from the constraints of a rigid peg. Besides, if for some reason a
shock originating abroad leads to a faster rise in prices in the rest of the world than at the
domestic level, a monetary policy that is not committed to defending a peg will also
contribute to limiting the impact on domestic prices.
This is not to imply that purely floating regimes will be the norm. They may have
important drawbacks when significant currency mismatches, high pass through to
domestic prices, or an important role of the foreign exchange in inflation expectations are
present. Managed floating should be preferred in this cases, as shown by the experience
of many developing economies (including inflation targeters8). Such experiences also
show that international reserves’ accumulation is an important prudential instrument to
deal with external shocks9; this is more so if climate change increases the volatility of
commodity prices and the occurrence of such shocks.
FINANCIAL STABILITY
Recent events have brought to the forefront the importance of financial regulation, at
the risk of facing adverse consequences in the real economy. Climate change adds a new
8
9
See Chang (2008).
See Redrado et al (2006).
9
item to the list of risks that banks have to learn to manage –namely, climate risk. Credit
risk evaluation will have to factor in the presence of unprecedented shocks to projected
loans, and banks will also have to make further provisions to their loan portfolio. Besides,
the emergence of markets for trading emission quotas is yet another challenging addition
to the complexity of financial markets; certainly, regulators will have to focus on the
specific financial and legal risks faced by participants in those markets.
MODELLING AND FORECASTING
Macroeconomic forecasting and modelling also become more complicated as a result
of climate change and the rising relative prices of commodities. The complexities poised
by these phenomena reduce the accuracy of the forecasts generated by models. The
estimation of the output gap, for instance, becomes more difficult. We may be able to
ascertain that the rate of growth in potential output will fall but probably not by how much.
Sudden bottlenecks provoked by adverse weather shocks may rapidly turn a situation of
excess supply in certain sectors into one of excess demand. And forecasting future prices
of commodities or natural resources, which is likely to be more important than ever, will be
more difficult. The poor forecasting power of commodity futures markets gives little ground
for optimism regarding this.
The practical consequences for monetary policy may be dire: it is common to model
the behavior of central banks as a rule that complies with price stability while stabilizing
the GDP around its potential level. If negative and persistent effects of global warming are
not appropriately taken into account in the potential GDP measure, a decrease in actual
GDP generated by a supply shock can be interpreted as a positive output gap and thus
will lead to an expansionary monetary policy, which then could be reflected in an
unnecessarily high inflation rate in the short term.
The phenomena we are discussing imply a dramatic change in the structure of the
economy and they may even lead to a change in the relative force of the different
channels of the transmission process, adding to the usual uncertainties surrounding the
“long and variable lags” of monetary policy. Thus, it is hard to believe that estimations
performed over a very different sample period could perform well under the new realities.
It is likely that monetary policy will have to rely even more heavily than in recent years on
judgment –bringing us back to the relevance of risk management, something that we
know first hand in developing countries.
A VIEW FROM THE DEVELOPING WORLD
10
The kinds of problems I have discussed so far are fairly familiar to central bankers in
emerging market countries. Unexpected supply shocks (out of changing weather
conditions, trade disruptions, new technologies, and so on), sudden changes in financial
market sentiment, the difficulty to reap the benefits of foreign exchange flexibility when
there is financial dollarization and high pass through, are all part of our everyday
concerns. This has led us to develop a number of strategies that differ to a considerable
extent from the standard “inflation targeting cum floating exchange rates” view, not in its
aims (macroeconomic stability) but in its operation. And we also know from direct
experience how coordination among policy makers can substantially improve outcomes –
and how its lack leads to very suboptimal results, to put it mildly. Let me mention a few of
these points.
ACCUMULATION OF INTERNATIONAL RESERVES
As a form of insurance against external shocks, this has been, I would say, the
common pattern all across the emerging world in recent years. Today, with no
international lender of last resort, there is no good substitute for sound external liquidity
policy at the country level. I am afraid it is the responsibility of every country to develop its
own set of countercyclical policies that would help offset limited access to financial
markets, without having a significant impact on domestic variables. Building a
precautionary cushion of foreign reserves is particularly important for emerging countries,
where there is a tighter connection between monetary, fiscal and financial stability. There
are also very successful examples of stabilization funds associated to commodity exports
that serve the same purpose. The latter could indeed be a model for the kind of actions
that could help us be better prepared for unexpected changes in weather conditions that
affect directly the production of commodities.
MANAGED FLOATING
A managed floating exchange rate regime enables us to weather situations of
economic or financial stress without leading to unwarranted changes in expectations and
financial disruption. We do not want to prevent variables from converging to their longterm values, but we would rather avoid excessive volatility as a source of unnecessary
disturbances in economic decisions. On the other hand, we do not want to provide any
sort of insurance that favors speculative flows –in short, a regime that, without providing
any sort of “foreign exchange insurance,” prevents excessive volatility from affecting
economic decisions. The benefits of this kind of policies are well-known. Empirical studies
11
find that even reaction functions of inflation targeting central banks in emerging countries
have a significant coefficient for the nominal exchange rate. And recent theoretical works
include segmentation and restricted access to financial markets into the analysis of
foreign exchange policy; the most relevant conclusions suggest that, in terms of
maximizing social welfare, the best choice is a less flexible foreign exchange regime
where access to hedging instruments is more limited. And this is a more realistic
conceptual framework for economies like ours.
FOSTERING POLICY COORDINATION
Our countries need an efficient (and effective) way of handling risks associated to the
reversal of currently benign conditions. Take, for instance, the strategy of accumulating
reserves; it certainly is an effective way of gaining liquid assets that may be used to
counter external shocks as the ones I have discussed; but it may not be the most efficient
solution, as a (supranational) pool of reserves may do the same job without requiring the
same individual effort from each country. There is a role for coordination here, perhaps
fostered by international financial institutions, in improving “risk management”. Needless
to say, when it comes to the question of the factors that underlie climate change,
coordination will be essential in trying to mitigate it through lower emissions. But problems
of collective action also arise when it comes to the choice of macroeconomic policies
aimed at responding to climate change. As shocks related to it may occur either at a
national or an international level, policies that focus only on individual countries may be
highly inefficient, even counterproductive –in the same way as “beggar-thy-neighbor”
policies are counterproductive for trade. Thus, coordination at an international level is of
the essence. This is certainly easier said than done, as different initiatives have shown so
far; still, the risks that we face are high enough as to force us to insist on the need for
coordination.
Let me sum up on what, I believe, are the main points of this discussion. However
uncertain the developments on climate change may be, the risks they entail are so high
that they deserve careful attention from economic policy. When it comes to central
banking, it does not appear that monetary policy by itself can do a particularly efficient job
of controlling or mitigating the factors that lead to climate change, a role for which fiscal
and industrial policy are better suited for. Instead, monetary policy can devote efforts to
adapt to climate change so that its contribution to macroeconomic stability is not
jeopardized. As climate change involves a more uncertain environment, a risk
management approach is the best way, in my view, to tackle the problem; in particular, the
12
standard inflation targeting approach should be modified in order to deal with persistent
supply shocks –through the use of countercyclical policies as reserve accumulation,
exchange rate management, and perhaps a more extensive use of informed judgment
than before. The bright side is that all this is by no means new to developing countries’
central banks, a number of tools that we have used over the years may serve to deal with
these new realities –by sharing our experience in this area, we may make a lasting
contribution to global macroeconomic stability. Thank you.
REFERENCES
-Chang, Roberto (2008): “Inflation Targeting, Reserves Accumulation, and Exchange Rate
Management in Latin America”, Borradores de Economía, Banco Central de Colombia, N°
487, 2008.
-Fine, Ben, Oliver Madison, Emily Paddon, Andrew Sniderman and Tom Rand (N/D):
“Green Bonds: A Public Policy Proposal”, Action Canada, Mimeo.
-IMF (2008) Chapter 4: “Climate Change and The Global Economy”, World Economic
Outlook, April; Prepared By Natalia Tamirisa, Florence Jaumotte, Ben Jones, Paul Mills,
Rodney Ramcharan, Alasdair Scott, and Jon Strand
-Liikanen, Erkki (2008): “Climate Change and Its Implications for Central Banks”, HighLevel Seminar of the EMEAP and the Euro Area Banca d'Italia, Rome, 27 June.
-Mendelsohn, Robert, Michael Schlesinger, and Larry Williams (2000) “Comparing
Impacts Across Climate Models,” Integrated Assessment, Vol. 1 (March)
-Nordhaus, William and Joseph Boyer (2000), Warming the World: Economic Models of
Global Warming (Cambridge, Massachusetts: MIT Press).
-Redrado, Martin, Jorge Carrera, Diego Bastourre and Javier Ibarlucia (2006): “The
Economic Policy of Foreign Reserve Accumulation: New International Evidence” BCRA
Paper Series | 2, Central Bank of Argentina, November.
-Reserve Bank of New Zealand (2007): “Monetary Policy Statement”, December.
-Stern, Nicholas, and Others (2007): The Economics of Climate Change: The Stern
Review (London: HM Treasury).
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