Climateflation and Monetary Policy in an Environmental OLG Growth Model

Abstract Central banks are gradually acknowledging that climate change can potentially impact price stability, and the term climateflation has entered the vocabulary of policymakers. The present paper contributes to the emerging literature around this concept. We develop an Overlapping Generations (OLG) model to study the interplay between conventional monetary policy and the environment when the so-called “independence hypothesis” does not hold, i.e. money is not neutral in the long run. We aim to provide some initial insights on the macroeconomic and environmental implications of using a Taylor rule to manage interest rates under two critical assumptions. First, environmental quality (degradation) has a positive (negative) externality on production through a damage function. Second, we innovate by linking the environment to inflation through expectations in a modified Phillips curve. Central banks shape wealth composition via the individual’s intertemporal optimisation problem, breaking the “independence hypothesis”. Numerical experiments allow us to assess the relationship between environmental quality and economic activity when (i) expectations are more responsive to climateflation , (ii) the monetary authority responds strongly to inflation deviations from its target, (iii) there is an increase in the inflation target, and (iv) whether fiscal policy is green expansionary.