Should central banks manage climate change risk via a CO2 emissions augmented Taylor rule? Evidence using a DSGE approach

Abstract

The detrimental effects of climate change are becoming pressingly apparent over the decades with policy-makers clumsily grappling with various policies to mitigate on its impacts on their respective economies. However, inefficiencies permeate in the implementation of these policies as they are being implemented only at the end of the process of economic activities. To resolve such a problem, this paper develops an innovative and novel approach to internalize CO2 emissions by proposing a ramified Taylor rule which captures a climate change premium, the level of which is directly dependent on the extent of deviation of actual CO2 emissions from its targeted level. The key benefits of the proposed tool are that not only effectiveness level is being bolstered by applying the tool right at the start of the process of economic activities but also that funds collected out of such a climate change premium could empower governments worldwide to vigorously green their economies. The model is tested for a given economy using the DSGE approach with findings attesting to the effectiveness of the proposed tool in curtailing the level CO2 emissions, independent of the type of monetary shock under scrutiny. Most importantly, depending on the extent of aggressiveness in mitigating the pollutants level, the parameter weight coefficient can be fine-tuned accordingly.