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Themacroeconomics ofgreentransitions by Gregor Boehl, Flora Budianto andElőd Takáts Monetary and Economic Department December 2024 JEL classification: O44, E31, E52, E58.Keywords: Energy transition, innovation, inflationdynamics, monetary policy. BISWorking Papers are written by members of the Monetary and EconomicDepartment of the Bank for International Settlements, and from time to time by othereconomists, and are published by the Bank. The papers are on subjects of topicalinterest and are technical in character. The views expressed in them are those of theirauthors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). ©Bank for International Settlements 2024. All rights reserved. Brief excerpts may bereproduced or translated provided the source is stated. The Macroeconomics of Green Transitions* Gregor Boehl„University of BonnFlora Budianto…TU WienEl˝od Tak´ats§BIS This Draft: November 2024First Draft: October 2024 Abstract The paper investigates the macroeconomics of an energy transition – a shift from brown togreen energy production through carbon taxation.Using a medium-scale DSGE model withenergy production sectors and endogenous innovation in the green energy sector, we show thatan energy transition – initiated through a brown energy tax – resembles a large supply sideshock, causing a surge in inflation and energy prices and a decline in consumption. Innovationincreases the efficiency of green energy production and drives energy prices down in the mediumrun. We document that monetary policy plays a critical role for the dynamics and pace of thetransition, even if the transition is not explicitly part of the policy rule. A monetary policy withless emphasis on inflation stabilization allows for temporarily higher inflation and energy prices,which boosts R&D and innovation, enhancing welfare and accelerating the transition. Keywords:Energy transition, innovation, inflation dynamics, monetary policyJEL-Codes:O44, E31, E52, E58 1Introduction One of the key challenges today is the transition from fossil fuels to renewable energy sources.In recent years, a growing global consensus has recognized the necessity of this shift to reducecarbon emissions and mitigate the risks of climate change.However, there remains a significantgap in understanding the economic consequences of this transition.How will it affect energyprices, inflation, and the broader economy? What role will economic policy, particularly monetarypolicy, play in shaping this process? In this paper, we explore these questions to shed light on themacroeconomic implications of the energy transition. To this end, we develop a model framework to study the transition dynamics of an economy inboth the short and medium run. Our model extends a medium-scale New Keynesian DSGE modelby three components. First, we introduce energy as an additional production factor alongside laborand capital.Energy is modeled as a mix of brown (fossil) and green (renewable) sources, eachproduced in distinct energy sectors. Second, we incorporate endogenous technological progress inthe green energy sector, allowing for innovation-driven efficiency gains.Finally, we assume theenergy transition is triggered by the implementation of a permanent tax on brown energy.Thistax creates a relative price distortion between brown and green energy production, encouraging agradual shift in demand and resources from the brown sector to the green sector. Over time, thisprice distortion drives the economy toward a new steady state with a larger share of green energyin the overall energy mix. In our framework, green innovation dynamics – based on Anzoategui et al. (2019) and Cominand Gertler (2006) – are endogenous, driven by larger incentives for research and development(R&D) when expected profits in green energy production are high. Innovation plays a central rolein expanding the range of technologies available for green energy production. Each firm producesgreen energy using a specific technology, so as the number of technologies increases, the number offirms in the market rises accordingly. This increased competition among firms enhances resourceallocation and boosts productivity in green energy production. Throughout our analysis, we assume that the central bank operates with ”traditional” objec-tives, specifically focusing on stabilizing inflation and output in line with a standard Taylor-typemonetary policy rule.Under this framework, the energy transition is not explicitly part of thecentral bank’s policy rule. However, we find that the conduct of monetary policy –particularly inhow effectively it stabilizes inflation in response to the brown energy tax– plays a crucial role inshaping the dynamics and pace of the transition process. The energy transition process unfolds as follows: In the short run, the brown energy tax raisesenergy prices, which subsequently increases production costs and aggregate inflation. Due