Climate actions and macro-financial stability: The role of central banks

Limiting global warming to well below 2 °C may pose threats to macroeconomic and financial stability. In an estimated Euro Area New Keynesian model with financial frictions and climate policy, we study the possible perils of a low-carbon transition and evaluate the role of monetary policy and financial regulation. We show that, even for very ambitious climate targets, transition costs are moderate along a timely and gradual mitigation pathway. Inflation volatility strongly increases for disorderly climate policy, demanding a strong monetary response by central banks. In reaction to an adverse financial shock originating in the fossil sector, a green quantitative easing policy can provide an effective stimulus to the economy, but its stabilizing properties do not significantly differ from those of market neutral asset purchase programs. A financial regulation, encouraging the decarbonization of the banks’ balance sheets via ad hoc capital requirements, can significantly reduce the severity of a financial crisis, but prolongs the recovery phase. Our results suggest that the involvement of central banks in climate actions must be carefully designed to be in compliance with their mandate and to avoid unintended trade-offs. • We develop a New Keynesian model with climate policy and financial frictions. • We study the role of financial regulation and monetary policy in a green transition. • The risk of macro-financial instability is limited for a gradual mitigation pathway. • Green quantitative easing programs stabilize the economy after a financial shock. • Differentiated capital requirements can mitigate the severity of a financial crisis.