Fir forest threatened with extinction

Monthly Report: Climate change and climate policy present new challenges for macroeconomic analysis

The global average temperature has risen markedly in recent decades. According to the latest issue of the Bundesbank’s Monthly Report, global warming can affect a country’s economic output in a number of ways. For example, high temperatures could lead to reduced working hours and lower labour productivity. On the other hand, countries with low initial temperatures could also benefit temporarily from rising temperatures – say, due to improving production conditions in agriculture. In addition to rising temperatures, climate change is accompanied by other effects, some varying greatly from region to region, explain the Bundesbank’s economists. These include, for instance, more frequent and more extreme weather events. These can give rise to disruptions to supply and demand that are both significant in macroeconomic terms and difficult to predict.

Own estimates indicate that the rise in temperatures over recent decades has also impacted economic developments in Europe. While these estimates do not reveal global warming to have had any statistically significant effects on economic growth in Germany and other large central European economies, they show that the temperature increase is already having a significant adverse impact in several southern European countries. According to the report, the economic implications of extreme weather events such as storms, floods and droughts for economic output also vary from region to region in Europe. That said, the macroeconomic losses incurred so far have not been high enough to be of major importance to monetary policy.

Why climate change has implications for the work of central banks

The consequences of climate change and climate policy have implications for the work of central banks. For example, rising average temperatures or more frequent extreme weather events may cause lasting harm to potential output growth. This would also narrow the room for manoeuvre for conventional monetary policy measures because a lower equilibrium real interest rate increases the likelihood of monetary policy hitting the zero lower bound. The consequences of climate change may also put pressure on the financial system and thereby make monetary policy transmission more difficult if, for instance, extreme weather events come with greater financial losses.

Alongside the macroeconomic impact of extreme weather events and gradually rising temperatures, attention is likely to turn to the impact of climate policy, in particular, in the near future. Measures such as significantly increasing the cost of greenhouse gas emissions are aimed at triggering far-reaching economic adjustment processes. This may make it more difficult to safeguard price and financial stability if, for example, profound structural change triggers a widespread revaluation of assets. Furthermore, it stands to reason that specific economic sectors and regions will be affected to widely varying degrees. This heterogeneity may have implications for aggregate growth.

Change in GDP growth for selected initial temperatures given a 1 °C rise in the average temperature
There have so far been very few studies on the impact of rising temperatures on economic developments in Europe. Calculations show that, while northern European countries appear to have benefited from the rising temperatures, their southern neighbours have been adversely affected. No statistically significant effects could be identified for western and central Europe (which includes Germany, France and the Netherlands).

Climate change will weigh more heavily on German economy in future 

While, in and of itself, climate change is not yet having an overly adverse effect on the German economy, the Bundesbank’s experts believe that this will not necessarily remain the case. Although the expected temperature increase will result in only relatively minor GDP losses in the current decade, in the absence of climate action its impact could intensify as of 2030, even if estimates of this kind (see the chart below) are subject to a high degree of uncertainty. In the experts’ view, timely and stringent climate policy measures would prevent some of the damage facing Germany in the future. They estimate the cost of delayed or poorly coordinated action to be significantly higher.

GDP level effects of the gradual rise in temperature in Germany
The report also looks at the macroeconomic impact of climate policy. This includes significantly increasing the cost of greenhouse gas emissions, e.g. by introducing emissions taxes, an emissions trading scheme or possible bans on certain emissions-intensive economic activities or products. Climate action of this kind would affect the economy in a variety of ways. Higher energy costs would put pressure on the budgets of both households and enterprises, for example. This would curb consumption and investment, with corresponding repercussions for wages, employment and aggregate demand. But climate action could also consist of creating incentives for businesses to innovate in a climate-friendly manner. This could reinforce technological progress and steer it in a climate-friendly direction, according to the report.

The overall result is a complex layering of supply and demand-side effects whose macroeconomic relevance is not always clear, write the experts. Taken by itself, prompt and decisive action would probably have an initial dampening effect on aggregate growth, but would reduce climate-related damage in the longer term and avoid costlier measures further down the line. “It is likely that higher carbon pricing would at least temporarily lead to higher inflation,” they explain, adding that the medium-term impact on economic growth also hinges on the design of climate policy and its predictability.

New Bundesbank model

It is not least because macroeconomic effects are likely to vary by region and economic sector that the experts at the Bundesbank are expanding their toolkit for climate policy analysis. One first step in this regard is the development of the new environmental multi-sector model, EMuSe, which can be used to analyse the impact of adjustment processes driven by climate policy both on the overall economy and individual economic sectors as well as in an international context. The model contains both key economic and ecological variables such as CO₂ emissions. In addition, it is possible to analyse international connections between up to three countries or regions.

EMuSe: The environmental multi-sector DSGE model of the Bundesbank