Monetary policy rules and environmental fiscal policy in a two-sector DSGE model

This paper examines how environmental externalities and fiscal policies aimed at reducing emissions affect the conduct of monetary policy in a two-sector (clean and dirty) environmental dynamic stochastic general equilibrium (E-DSGE) model. We analyze the response of monetary policy to sector-specific inflationary shocks under different environmental policy regimes and compare the performance of standard and non-standard monetary policy rules. In our framework, while the sectors are symmetric in terms of technology and nominal price rigidity, environmental fiscal policies -- such as carbon taxes or emission caps that affect only the dirty sector -- generate relative price distortions. Our findings highlight three key results. First, environmental policies introduce distortions in relative prices, altering the conduct of (Ramsey) optimal monetary policy. Second, a non-standard monetary rule targeting sector-specific inflation mitigates output, inflation, and emissions volatility more effectively. Third, this non-standard rule improves welfare across all environmental policy scenarios but leads to higher emissions, except under a cap policy, where emissions remain fixed by design. These findings underscore the critical role of policy-induced price asymmetries, besides structural ones, in shaping monetary policy responses, and reveal the complex interplay between monetary and environmental fiscal policies along with the trade-offs in designing optimal policy frameworks.