Optimal Climate Policy with Incomplete Markets

Abstract:

This paper examines dynamic, optimal climate policy in a fiscal climate-economy model with incomplete markets. Initially, in a simple two-period model, we isolate several mechanisms through which inequality, risk, and borrowing constraints affect optimal climate policy. We then introduce a new fiscal climate-economy framework with incomplete markets, which we calibrate to reflect critical aspects of the U.S. economy, particularly household inequality and risk, carbon emissions, and abatement technologies. Within this framework, we solve a Ramsey problem for a government that has access to multiple instruments, including carbon taxes and government debt. In all scenarios, optimal carbon taxes grow at a faster rate than GDP until the economy reaches carbon neutrality. Moreover, we show that granting the planner the flexibility to determine the timing of debt and lump-sum transfers significantly affects redistribution, insurance, aggregate variables, and welfare. Yet, surprisingly, this flexibility has minimal influence on the optimal trajectory of climate policy.