New Research ; Is it possible for fluctuations in the Fed’s interest rates to impact the environment and pollution levels?

A recent study by Florida Atlantic University’s College of Business suggests that changes in monetary policy, such as the United States Federal Reserve’s decision to increase interest rates, can have an impact on the environment.

Researchers investigated the effects of traditional monetary tools, such as short-term interest rate changes, on the environment by utilizing a stylized dynamic aggregate demand-aggregate supply (AD-AS) model. The study focused on the short and long-term consequences of monetary policy on CO2 emissions. The AD-AS model represents the interconnected relationships between four macroeconomic objectives: economic growth, unemployment, inflation, and a sustainable balance of trade.

In their study, the researchers utilized the Global Vector AutoRegressive (GVAR) methodology, which links different regions through an explicit economic integration measure, specifically bilateral trade, to account for spillover effects.

The study’s authors, including Joao Ricardo Faria, Ph.D., a professor in FAU’s College of Business Economics Department, and collaborators from Federal University of Ouro Preto and the University of São Paulo in Brazil, analyzed four regions: the U.S., United Kingdom, Japan, and the Eurozone, which comprises all European Union countries that have adopted the euro as their national currency.

The researchers utilized data from eight different countries to analyze the global economy and the impact of policy changes. Their approach involved modeling the interplay between these countries, in order to assess the effects of policy shifts not only on domestic outcomes but also on other economies.

The study, which was published in the Journal Energy Economics, found that monetary policy has a primarily domestic impact on pollution. Specifically, when a region implements a monetary contraction or reduction, its own emissions decrease, but there is no noticeable effect on emissions in other economies. However, the researchers caution that this does not mean that the international economy is irrelevant to determining a region’s emissions level.

“The actions of a country, like the U.S., are not restricted to its borders. For example, a positive shock in the Federal Reserve’s monetary policy may cause adjustments in the whole system, including the carbon emissions of the other regions,” said Faria.

In this study, a comprehensive approach was taken to examine the impact of various policies on carbon dioxide emissions across different regions, including the United States and other economies. By analyzing four distinct regions, the study was able to compare and contrast how domestic markets respond to the same policies.

The study also revealed notable variations between regions. For instance, monetary policy was found to have limited effectiveness in reducing short-term emissions in the United Kingdom, and long-term emissions in the Eurozone. Interestingly, Japan was found to have a much stronger relationship between monetary policy and CO2 emissions compared to other regions, as indicated by a larger cointegration coefficient. Moreover, the cointegration analysis suggested that there is a long-term correlation between interest rates and emissions.

According to statistical analyses, external factors play a significant role in explaining the variations in emissions observed in different regions. A considerable proportion of the changes in domestic CO2 emissions are attributable to external factors.

“Findings from our study suggest efforts to reduce emissions can benefit from internationally coordinated policies,” said Faria. “Thus, the main policy prescription is to increase international coordination and efforts to reduce CO2 emissions. We realize that achieving coordination is not an easy endeavor despite international efforts to reduce carbon emissions, such as the Paris Agreement. Our paper highlights the payoffs of coordinated policies. We hope it motivates future research on how to achieve successful coordination.”

Source of Study ; Luccas Assis Attílio, João Ricardo Faria, Mauro Rodrigues. Does monetary policy impact CO2 emissions? A GVAR analysis. Energy Economics, 2023; 119: 106559 DOI: 10.1016/j.eneco.2023.106559