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| In this paper we discuss how environmental damage and emission reduction policies affect the conduct of monetary policy in a two-sector (clean and dirty) dynamic stochastic general equilibrium model. In particular we examine the optimal response of the interest rate to changes in sectoral inflation due to standard supply shocks conditional on a given environmental policy. We then compare the performance of a nonstandard monetary rule with sectoral inflation targets to that of a standard Taylor rule. Our main results are as follows: first the optimal monetary policy is affected by the existence of environmental policy (carbon taxation) as this introduces a distortion in the relative price level between the clean and dirty sectors. Second compared with a standard Taylor rule targeting aggregate inflation a monetary policy rule with asymmetric responses to sector-specific inflation allows for reduced volatility in the inflation gap output gap and emissions. Third a nonstandard monetary policy rule allows for a higher level of welfare so the two goals of welfare maximization and emission minimization can be aligned. |
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