Transition Risks in a Small Open Economy: An EDSGE Model with Blue Firms, Financial Frictions and Macroprudential Policy

Authors: Wright A , McIntosh J , Dames L , Ward L* , Rolle N and Branch S

DOI: 10.23880/jenr-16000415

Volume 9, Issue 3

Abstract

While mitigation and adaptation measures are effective in fighting climate change, there are transition risks linked to these efforts that can impact output. However, the right mix of policies can help to alleviate transition risks, thereby mitigating the associated economic impact. This study explores the economic effects of a carbon tax in an economy featuring “blue firms” that capture carbon. Extending Carattini, et al. we develop a dynamic stochastic general equilibrium (DSGE) model with financial frictions and macroprudential policy, integrating blue firms with brown (polluting) and green firms. The results show that macroprudential policy mitigates transition risks, and blue firms enable a smoother economic shift under a carbon tax, enhancing welfare by up to 5.34% in the combined model. To note, the findings also reveal that while macroprudential policies can dampen credit cycles and reduce volatility, they do not substitute for environmental regulation.

Keywords: Climate Change; Transition Risk; DSGE Model; Blue Firms

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