The dynamic effects of environmental and fiscal policy shocks

This paper investigates the dynamic effects of environmental and fiscal policy shocks in a New Keynesian dynamic stochastic general equilibrium model featuring price and wage rigidity and a polluting intermediate goods sector. I compare carbon taxes and cap-and-trade systems under abatement cost and government spending shocks, considering three revenue-recycling schemes: lump-sum transfers, labor tax cuts, and consumption tax cuts. Abatement cost shocks reduce output and consumption, with stronger effects under cap-and-trade due to rising permit prices. These effects are mitigated when revenues are used to reduce distortionary taxes, especially consumption taxes. Government spending shocks stimulate output and labor, particularly under lump-sum financing, but their expansionary effects are dampened under cap-and-trade. Nominal rigidities amplify these dynamics. The findings support the double dividend hypothesis and highlight the importance of fiscal design and policy coordination. Carbon taxes, combined with targeted tax reductions, offer superior macroeconomic stabilization in the face of environmental and fiscal shocks.