Can the Federal Reserve Save the Environment?

Abstract

This paper studies the effect of monetary policy on environmental quality via the channel of global value chains (GVCs). From a proxy-VAR analysis with U.S. monetary policy surprise as an external instrument, we show that a contractionary monetary policy which escalates domestic credit costs and induces stronger local currency has a causal effect of reducing emissions, but more importantly, raising emission intensities due to firms’ discouraged participation to GVCs which, in turn, entails reduction in pollution offshoring. This result indicates that monetary policies primarily aiming for economic stabilization have unrecognized environmental externality.

Keywords: Domestic Credit Cost, Emission, Emission Intensity, Global Value Chain, Monetary Policy, Real Effective Exchange Rate

JEL Classification: E52, F18, F41, Q53