Can the Federal Reserve save the environment?

Abstract

This study examines the environmental effect of monetary policy, particularly within the framework of global value chains (GVCs). Given the escalating climate concerns and the urgent need for sustainable solutions, it is crucial to investigate the environmental consequences of monetary policy decisions which directly influence domestic production and international input-sourcing activities. As the monetary policy is likely to be associated with a variety of economic factors influencing environmental outcomes, it is critical to introduce an exogenous shock that reflects variations in monetary policies to derive unbiased causal estimates. We thus adopt a proxy-vector autoregression (VAR) approach with U.S. monetary policy surprise as an exogenous instrument. We uncover compelling evidence that one standard deviation of contractionary monetary policy surprise leads to a reduction in overall emissions by approximately 0.5 percent. However, the more significant and concerning result is the observed rise in emission intensities by 0.2 percent. We highlight the key mechanism underlying this outcome: higher domestic credit costs discourage firms from effectively outsourcing production tasks abroad, thereby increasing the generation of air pollutants per unit of output arising from reduced production efficiency. The identification of a previously unrecognized environmental externality calls for a reevaluation of policy approaches and underscores the importance of integrating environmental considerations into monetary policy frameworks.