How Should Environmental Policy Respond to Business Cycles? Optimal Policy under Persistent Productivity Shocks

How should environmental policy respond to economic fluctuations caused by persistent productivity shocks? This paper answers that question by presenting and solving a dynamic stochastic general equilibrium real business cycle model that includes an externality from pollution. The model is estimated and calibrated to consider the US economy and emissions of carbon dioxide. I find that optimal policy allows emissions to be procyclical: increasing during expansions and decreasing during contractions. However, optimal policy dampens the procyclicality of emissions compared to the unregulated case. A price effect costlier abatement during booms outweighs an income effect of greater demand for clean air. I also model a decentralized economy, where government chooses an emissions tax or quantity restriction and firms and consumers respond. The optimal emissions tax rate and the optimal emissions quota are both procyclical: during recessions, the tax rate and the emissions quota both decrease