The macroeconomics of green transitions

Summary

Focus

We analyse the macroeconomic implications of a green energy transition. Major economies increasingly recognise the need to shift from fossil fuels to renewable energy sources to reduce carbon emissions and address the risks of climate change. We examine the effects of this transition on energy prices, inflation and the broader economy. A particular focus is on the role of economic policy – especially monetary policy – in shaping the transition process.

Contribution

We develop a macroeconomic framework to study the dynamics of the energy transition in the short and medium run. Our framework builds on a medium-scale New Keynesian model with three key extensions. First, we introduce an energy sector with fossil (brown) and renewable (green) energy as production inputs. Second, we allow for endogenous technological progress in the green energy sector, which enhances its efficiency over time. Third, we introduce a carbon tax that raises the cost of producing brown energy relative to green energy, initiating the transition towards a smaller share of brown energy in the overall energy mix.

Findings

The energy transition resembles a large and persistent supply-side shock. The carbon tax increases energy prices and inflation and reduces consumption. It also raises relative demand for green energy, reallocating resources towards green energy production and research and development (R&D) in new green technologies. Monetary policy plays a pivotal role in this transition. A monetary policy with less emphasis on stabilising inflation keeps energy prices higher, strengthening incentives for R&D investment. This fosters technological growth and accelerates the energy transition. Our welfare analysis highlights a key trade-off for monetary policy: weaker inflation stabilisation results in temporarily higher inflation but enables a faster transition over time, ultimately balancing short-term costs with long-term benefits.

Abstract

The paper investigates the macroeconomics of an energy transition – a shift from brown to green energy production through carbon taxation. Using a medium-scale DSGE model with energy production sectors and endogenous innovation in the green energy sector, we show that an energy transition – initiated through a brown energy tax – resembles a large supply side shock, causing a surge in inflation and energy prices and a decline in consumption. Innovation increases the efficiency of green energy production and drives energy prices down in the medium run. We document that monetary policy plays a critical role for the dynamics and pace of the transition, even if the transition is not explicitly part of the policy rule. A monetary policy with less emphasis on inflation stabilization allows for temporarily higher inflation and energy prices, which boosts R&D and innovation, enhancing welfare and accelerating the transition.

JEL classification: O44, E31, E52, E58

Keywords: energy transition, innovation, inflation dynamics, monetary policy