Key Details
Bank of England Staff Working Paper No. 1,211, Navigating Climate Policy Shocks: Optimal Monetary Policy Responses, uses a euro-area-calibrated economic model to compare the effects of higher carbon prices and green-energy subsidies.
Higher carbon price: Fossil energy becomes more expensive; in the model, inflation rises and output falls. Its welfare-maximising response is a temporary interest-rate reduction to cushion the loss of activity.
Higher green subsidy: Energy becomes cheaper and overall output rises. The model instead favours a rate increase to limit economic fluctuations.
Inflation measures: A rule responding to core inflation—which excludes energy in this model—generally performs better than one responding only to headline inflation after a carbon-price increase. The difference narrows when the rule also responds to economic activity.
Combined policy: Using carbon-pricing revenue to fund green subsidies achieves a comparable modelled emissions reduction with less energy-price and output volatility than either measure alone.
Energy Costs Create a Difficult Inflation–Growth Trade-Off
A carbon price discourages fossil-fuel use, but it also raises the cost of energy used by households and businesses. In the paper’s model, headline inflation increases as production and consumption weaken. Raising interest rates solely to counter the initial inflation increase would compound the downturn.
The authors’ preferred response is therefore to lower rates temporarily, supporting spending and employment while maintaining a credible commitment to medium-term price stability. This is not a general prescription to cut rates whenever energy prices rise. The result depends in part on the model’s assumption that households and firms cannot readily substitute away from energy.
Green Subsidies Produce the Opposite Monetary Response
A subsidy makes clean energy cheaper and encourages a shift away from fossil energy. In the model, it lowers inflation and raises overall output. Yet the increase in output is driven by greater energy consumption; production and consumption outside the energy sector can decline. The authors find that a rate increase limits the resulting fluctuations.
These contrasting results show why the monetary implications of climate policy depend on which instrument changes energy prices, not simply on whether a measure advances the energy transition.
Climate-Policy Design Can Ease the Trade-Off
The paper also examines a package in which carbon-pricing revenue funds green-energy subsidies. In that simulation, the measures offset much of each other’s effect on overall energy prices. The package meets the modelled emissions-reduction objective with milder inflation and output movements, leaving monetary policy with less stabilisation to do.
Policy Relevance
The paper offers a useful way for Indian policymakers to examine the joint effects of climate and monetary policy. A change in energy taxation or subsidy design can affect both prices and economic activity; assessing only its immediate effect on headline inflation would miss part of that picture. How carbon-pricing revenue is used also matters to the result.
Its interest-rate findings should not be transferred directly to the RBI. This is a theoretical exercise calibrated to the euro area, with specific assumptions about energy use, household transfers and fiscal financing. For India, the relevant next step is to test how different energy-policy designs would affect domestic inflation, output and households under Indian conditions.
Follow the Full Working Paper Here: Navigating Climate Policy Shocks: Optimal Monetary Policy Responses