Short-Term Macroeconomics and Climate Policy: A Few Lessons from an Aggregate Supply and Demand Model

This article introduces the concept of carbon footprint into an aggregate supply and demand model with imperfectly competitive price and wage formation. We analyze the properties of short-term macroeconomic equilibrium in the presence of a climate policy. This may take the form of either a carbon tax or quotas of pollution permits. We show that, in the short run, climate policy (or its strengthening) is simultaneously a negative aggregate supply shock and a positive aggregate demand shock. It is thus inflationary, but its impact on aggregate economic activity and employment is ambiguous: it will only stimulate output in an economy where nominal wages are rigid enough. In all cases, climate policy will depress real wages. We also analyze the interactions between climate policy and the usual macroeconomic policies of supply (labour tax cut) and demand (fiscal and monetary stimuli). The multiplier effects of these supply and demand policies depend on the instrument chosen for implementing the climate policy (carbon tax or pollution permits). Finally, we establish the conditions under which reform, combining the strengthening of a climate policy and a labour tax cut, can reach the double objective of a lower carbon footprint and a lower unemployment rate without reducing workers’ real wages. Such policy reform, however, has an ambiguous impact on the government surplus (or deficit). JEL Classification: E10, E60, Q58.