Climate Policies, Macroprudential Regulation, and the Welfare Cost of Business Cycles

This paper embeds a carbon pricing sector into an extended DSGE model with a financial accelerator (E-DSGE) featuring heterogeneous firms, bank monitoring, and a borrowing-constraint amplification mechanism, then compares the welfare cost of business cycles under a cap-and-trade (CAT) scheme versus a carbon tax. The central result is that, in the presence of financial frictions, CAT generates lower welfare costs than a carbon tax: under TFP and risk shocks calibrated to US quarterly data, the baseline welfare cost of business cycles is 0.6178 percent of consumption under CAT versus 1.5231 percent under a carbon tax — roughly 2.5 times larger under a tax. The mechanism is that permit prices under CAT are procyclical (they fall in downturns, reducing firms’ carbon compliance burden precisely when balance sheets are most stressed), acting as an automatic stabilizer for financial amplification, while the carbon tax holds a fixed price and provides no such buffer. A countercyclical optimal carbon tax rule that reacts vigorously to output (optimal sensitivity parameter τ = 52.2245) can mimic CAT’s stabilizing behavior, but even optimized environmental rules leave a significant welfare gap between regimes. Reserve requirement macroprudential regulation narrows this gap substantially: a static 2 percent reserve requirement brings CAT welfare costs to 0.1957 and carbon tax costs to 0.3863; an optimal dynamic rule keyed to credit growth or asset price growth brings both regimes below 0.20, effectively aligning them. A deposit interest rate subsidy can also narrow the gap when combined with a dynamic subsidy rule, but a static subsidy actually worsens welfare costs because it raises leverage and amplifies shocks around a more fragile steady state.

Marco Carli | Macro Paper Warehouse

Climate Policies, Macroprudential Regulation, and the Welfare Cost of Business Cycles