Monetary and Environmental Policy in a Heterogeneous Agent Model

In this paper, we explore the interaction of monetary policy and a regulatory policy for controlling pollution within an economy populated with financially constrained producers exhibiting heterogeneity in production technology and pollution rates. Environment related components of the model include pollution externality, an abatement technology and environmental policy in the form of tax on pollutants. Our analysis is organized around two main topics: assessing the effect of monetary policy on social welfare in the presence of environmental concerns and investigating how the existence of pollution-type externality and environmental regulation influences optimal monetary policy. Our findings suggest that in the presence of heterogeneity, due to its distributional impact, monetary policy can play a role in enhancing social welfare and complementing regulatory efforts to mitigate pollution. In our model, featuring heterogeneity in productivity and pollution intensity, monetary policy influences social welfare through both pollution and consumption. The impact of monetary policy on pollution occurs indirectly through change in the allocation of production. The impact of monetary policy on consumption operates through real wage adjustments and money transfers. Furthermore, the indirect effect on consumption arises from the impact of monetary policy on optimal regulatory policy. Money growth that redirects production away from the pollutant agent creates a room for looser regulatory policy, leading to higher consumption.