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Optimal policies in a small open economy with an environmental externality and shallow foreign exchange markets

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A Correction to this article was published on 11 April 2024

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Abstract

This paper develops a small open economy model with a brown and green industry. Brown firms generate an environmental externality that reduces the utility of domestic households. Firms in both sectors rely on domestic and foreign capital to finance their production. Foreign exchange markets are assumed to be shallow and firms pay a higher return to borrow capital with respect to the exogenous foreign interest rate. This inefficiency contributes to a further decline in welfare. In this framework, the first-best allocation is attained through a tax on the output produced by the polluting sector combined with differentiated capital controls, with a higher tax rate applied to foreign capital inflows in the brown sector and a lower tax rate applied to foreign inflows in green firms. Looking at single policy tools, such differentiated capital controls are preferable to a tax on brown production for moderate values of the environmental externality.

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Data availability

No new data were analysed in support of this research. The code used to solve the model is written in R and will be shared on reasonable request to the corresponding author.

Change history

Notes

  1. For a recent review of the debate and measures aimed at the mitigation of climate-related risks within central banks’ financial stability mandate, see Bolton et al. (2020).

  2. In these works, the authors introduce an extra-utility for green asset holdings in a mean–variance utility framework.

  3. As in Basu et al. (2020), we assume that domestic households can only trade domestic bonds, while international financial intermediaries can trade both domestic and foreign assets. This simplifying assumption is consistent with the empirical evidence on home bias in financial choices in emerging countries (see Coeurdacier and Rey 2013, for a review).

  4. This inequality is consistent with the empirical evidence that finds an excess return for brown bonds in comparison to comparable green assets: e.g., Ehlers and Packer (2017), Gianfrate and Peri (2019), Zerbib (2019) and Baker et al. (2022) find that the yield of a green bond is lower than that of a conventional bond after conditioning on common characteristics (such as rating, sector, maturity). In particular, the authors of these papers explain the lower return of green bonds with the existence of market pro-environmental preferences.

  5. See Gabaix and Maggiori (2015) for a microfoundation of these equations.

  6. In fact, according to the traditional economic view, environmental compliance generally forces firms to devote some part of inputs to pollution prevention and abatement, which are not considered as value added, or to curb production (Jaffe et al. 1995; Ambec et al. 2013). See also Kozluk and Zipperer (2015), for a review of the evidence on the relationship between environmental policy and productivity.

  7. It is important to stress that the solution of the model can be interpreted as a long-run stationary equilibrium rather than the adjustment path toward such equilibrium, in which the output tax or capital controls might have heterogeneous effects on the different generations involved in the transition.

  8. In fact, there is no a priori reason or empirical evidence (to the best of our knowledge) supporting the hypothesis of a stronger pro-environmental attitude of foreign investors relative to domestic households.

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  1. Bank of Italy, International Relations and Economics Directorate, Rome, Italy

    Alessandro Moro

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The views expressed in the paper are those of the author and do not involve the responsibility of the Bank of Italy. I would like to thank Pietro Antonio Catte, Federico Cingano, Antonio Di Cesare, Valerio Nispi Landi, Francesco Paternò, Luigi Federico Signorini, and two Bank of Italy’s anonymous referees for very helpful comments and suggestions on an earlier version of this paper entitled “Can capital controls promote green investments in developing countries?”. I thank the journal’s anonymous referee for the insightful comments and suggestions that have greatly contributed to the quality of the paper.

The original version of this article was revised. The convexity of the brown investment disutility should be denoted by φ (instead of ϕ).

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Moro, A. Optimal policies in a small open economy with an environmental externality and shallow foreign exchange markets. Port Econ J (2024). https://doi.org/10.1007/s10258-024-00253-w

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