Future of Monetary Policy in the Context of Global Warming and Recession

By S Aswathi Mohan,

(Image source: The Economic Times)

Monetary Policy is a tool used by a nation’s Central Bank to influence the nation’s price levels, output, etc as a response to global shocks. Global warming is the rise of the average temperature of the Earth due to the emission of greenhouse gases like carbon dioxide, while recession is a period of economic slowdown characterised by low consumption and reduced trade and industrial activity. So how are they related to each other?

The answer is economic shocks.

Economic Shocks

An economic shock is an event that brings about a significant change in the economy. It can either affect the aggregate demand or aggregate supply of an economy. Negative economic shocks affect the economy by causing a reduction in the output and hence employment of the economy, leading the economy to a recession stage.

Global Warming-Shock Relation

Global warming is responsible for many drastic changes in the climate. It causes droughts, a change in biodiversity, people to migrate due to unfavourable climatic conditions, etc. These drastic changes affect the supply of commodities used as inputs, thus creating supply-side shocks. These shocks lead to a fall in output (because supply of the commodity has decreased) as well as an increase in the prices of the output, leading to a phase of recession as well as inflation — a condition known as stagflation.

In 2018, the hot summer in Germany had caused the water levels of rivers to reduce and the spreading of drought. This had a huge impact on the country’s shipping as well as agricultural industry. Freight prices increased and it affected the oil supply of the country. There were huge agricultural losses with a shortage of feed for livestock as well as the forecast that the country’s harvest might drop to 36 million tons compared to an average of 47.9 million tons over the last five years.1

The above example highlights how catastrophic the effects of global warming can be.

Why are Central Banks Concerned Now?

Earlier, the effects of climate change were thought to be temporary. However, Central Banks have come to realise that the longer the risks of climate change ignored, the higher the risks of shocks, which may have irreversible consequences to the economy. They have also realised that climate changes pose a serious challenge to their ability to correctly identify economic shocks.

Dilemma of Monetary Policymakers

In the presence of stagflation, monetary policymakers face a trade-off to control price or output. If they try to control inflation by increasing the interest rate (thus decreasing the money supply), it would lead to further reduction in output (because aggregate demand decreases as people have less money to spend, investments decrease due to higher rates of borrowing). And, if they aim to control output fluctuations by reducing the interest rates and increasing money supply, it would further increase the price levels.

What should be Done?

Monetary policymakers should make their decisions based upon their priorities – whether to stabilise output or price level. The best way would be if they work hand-in-hand with the government, who is responsible for fiscal policies (policies which relate to government spending and taxation). If monetary and fiscal policies are complementary in nature, then the effects of the negative supply-side shocks caused due to global warming can be countered. By establishing a contractionary monetary policy, inflation can be reduced. At the same time, expansionary fiscal policy through increased government spending and reduction in taxation can stimulate the aggregate demand, reducing the effect on output by the monetary policy.

Measures Taken by Central Banks to Address the Problem

The Central Banks and Supervisors Network for Greening the Financial System (NGFS) was formed to better understand and manage the financial risks and opportunity of climate change. In Lebanon, the amount of reserves a private bank needs to keep at the central bank depends on how much it lends to renewable energy ventures. In Bangladesh, banks can expect preferential terms when they borrow from the central bank if they pass on the money as green loans.2

(Aswathi Mohan is a Research Intern at Centre for Public Policy Research. Views expressed by the author are personal and need not reflect or represent the views of Centre for Public Policy Research)

1 https://phys.org/news/2018-10-river-chaos-germany.html

2 Bloomberg