Our new macroeconomic model: bringing in the environment

Photo credit:   Tony Fischer Photography

October 22, 2013 // By: Giovanni Bernardo

The model presented below aims to show how economic growth, the financial system and the environment interact. It is necessary to understand these relationships, which are by no means simple, in order to develop policy that better meets environmental targets. Here, we focus in particular on two options for government – the use of “green taxes”, and what we have labeled “green credit guidance”: the provision of cheap funding for particular, green, investments.

As we have argued in the past, mainstream macroeconomic models do not full take account of the financial sector. This is because the conventional framework assumes a “dichotomy” between the long-run and the short-run, and between the micro and the macro levels. Financial issues are treated only in the short run and on a micro level, and thus do not affect long term issues, like growth. This “dichotomy” is based on very specific assumptions about the full utilization of available resources, and of perfect markets that operate as if straight out of a textbook, with none of the obvious imperfections we see in real markets – monopolies, cartels, problems of access to information, and so on.

These restrictions help ensure that the demand side of the economy is irrelevant in terms of affecting output, at least in the long-term. The driver of the whole economy is the supply-side – what firms choose to produce, given their own desire to maximize their profits, at any point in time. By focusing solely on the supply-side, we drop the important consideration of how firms decide what to produce, and it is in considering this decision by firms that we can see how the demand-side might matter over time.

In particular, these theoretical restrictions in conventional models also pose important limitations on our understanding of the environment-growth nexus. The absence of the financial sector in joint macro-environmental models leads to conclusions such that lower consumption will lead to higher savings which can be used for mitigation. These conclusions cannot be drawn if one takes into account the functioning of the modern financial system.

The model presented here shows, in a formal setting, the link between nef’s previous money creation model and the environment by introducing different types of energy consumption - renewable and non-renewable. This energy consumed is used in order to produce a given amount of output, and the amount of energy used depends on the energy-efficiency of the technology used. The amount of non-renewable energy used in production, in turn, provides a direct link to the volume of greenhouse gas emissions in the atmosphere. We have also introduced a government which is here able to invest in mitigation (to reduce the impact of greenhouse gas emissions) and is also able to impose rules on the commercial banks.

We test the effects of three different policies in order to highlight the importance of the financial sector in environmental variables. The main link in our framework, towards this direction is what we call “green credit guidance”.

Green credit guidance (GCG) is a form of window guidance monetary policy that imposes a restriction on the private banks over the loans they are allowed to extend. They are forced, with the GCG in place, to allocate a certain percentage of their total loans made to spending on energy efficiency.

The simulations of the effects of the different policies show that GCG could potentially reduce the volume of greenhouse gasses (GHG) without reducing GDP. Using both GCG and a green tax policy, with taxation increasing as GHG emissions rise, we can decouple GHG emissions from economic growth at the cost of only a small reduction to the long-run (“steady state”) growth rate. However, this decoupling cannot be achieved along an exponential growth path, with growth accelerating forever into the future.

The aim of this strand of research has been to being to show more clearly the relationships between finance, growth and environmental variables that are all but nonexistent in the mainstream theory, and that have not been explicitly developed in other non-orthodox economic models. This model is not the end, but rather the beginning of the development of these links. This framework can potentially provide the basis for investigating issues like the effects of full employment or higher investment in mitigation to environmental limits and financial stability.

Issues

Macroeconomics, Environment

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