Optimal Climate Change Mitigation through Green Quantitative Easing and Fiscal Policy

We address the question of how green quantitative easing could complement governments’ toolkit for climate change mitigation. In our setup, green quantitative easing refers to a given outstanding stock of bonds held by the European Central Bank and its portfolio allocation between a clean and dirty sector of production. Our key research question is how the central bank can contribute to an optimal inter-generational sharing of the burden of climate change policies in comparison to, or in combination with, fiscal mitigation policies.

We develop a quantitative overlapping generations model in which households consume and allocate their savings and their work efforts between a clean and dirty production sector. A reallocation of the central bank portfolio toward the clean sector increases the capital stock employed for production in that sector relative to the capital stock in the dirty sector. This triggers a relative increase of labour demand in the clean sector and a relative expansion of output. Through this mechanism, the central bank can thus influence relative production across the two sectors in the economy. We then contrast this policy with fiscal policy measures to mitigate climate change. We will explore whether the central bank can improve the economic allocation beyond what is thus achieved through fiscal policy.

Holding constant the balance sheet of the central bank enables us to focus on the portfolio reallocation mechanism. However, it limits the interaction between fiscal and monetary policy in the model. As a next step, we extend the model by an explicit notion of money and the introduction of a distortion that requires bond purchases by the central bank, which will enable us to study the effects of an expansion of central bank bond holdings and of climate policy interactions.