Optimal environmental policy and business cycles: An analysis using an E2-DSGE model

What are the effects of adopting a comprehensive environmental policy that considers, in addition to taxes on emissions, taxes and subsidies in the energy sector? This paper answers that question using a dynamic stochastic general equilibrium model augmented to include environmental issues and an energy sector featuring non-renewable and renewable energy production. The model is used to find the optimal trajectories of the environmental policy instruments and to analyze the dynamic behavior of the model variables in response to productivity shocks. First, we show that tax and subsidy rates are procyclical. Second, we show that having access to alternative sources of (renewable) energy allows households and firms to replace non-renewable (polluting) energy sources with renewable (cleaner) energy sources in response to productivity shocks. Finally, a welfare analysis of different policy alternatives shows that a broad environmental policy is welfare superior to policies that do not include a full set of taxes and subsidies in the energy sector.