Does monetary policy really matter for environmental protection? The case of inflation targeting

Abstract

Empirical work examining the role of monetary policy on environmental issues are rather scarce. This study examines how inflation targeting (IT) relates to environmental pollution in samples of 22 Developed Market Economies (DMEs) and 25 Emerging Market Economies (EMEs) over the period 1980–2017. Using a parametric approach (two-step system-generalized method of moments), we find that IT significantly reduces emissions of polluting gases, specifically carbon dioxide (CO2), nitrous oxide (N2O), methane (CH4), and total greenhouse gases (GHG) in DMEs and EMEs. In order to take into account, the existence of a potential self-selection bias in the adoption of IT, we subsequently resorted to a non-parametric approach, namely propensity score matching. The results confirm those obtained in the parametric approach. Then, using structural equation modeling, we find that IT reduces environmental pollution mainly through the financial instability channel. In addition, based on the insights from the recent literature, we test the moderating role of financial development and financial stability. The results indicate that these variables reduce the “green effect” of IT. Ultimately, our findings provide an interesting empirical basis for policymakers to help them build a sound macroeconomic and financial framework that promotes more environmentally friendly financial behaviors.