Environmental Policy Instrument Choice and International Trade

By J. Scott Holladay, Mohammed Mohsin and Shreekar Pradhan


We develop a dynamic stochastic general equilibrium model to understand how environmental policy instrument choice affects trade. We extend the existing literature by employing an open economy model to evaluate three environmental policy instruments: cap-and-trade, pollution taxes, and an emissions intensity standard in the face of two types of exogenous shocks. We calibrate the model to Canadian data and simulate productivity and import price shocks. We evaluate the evolution of key macroeconomic variables, including the trade balance in response to the shocks under each policy instrument. Our findings for the evolution of output and emissions under a productivity shock are consistent with previous closed economy models. Our open economy framework allows us to find that a cap-and-trade policy dampens the international trade effects of the business cycle relative to an emissions tax or intensity standard. Under an import shock, pollution taxes and intensity targets are as effective as cap-and-trade policies in reducing variance in consumption and employment. The cap-and-trade policy limits the intensity of the import competition shock suggesting that particular policy instrument might serve as a barrier to trade.

While it is not the principal purpose of environmental policy, it is nice to know that it does not amplify business cycles. But I suspect that it matters how pollution enters the model. In this case, it is through a production loss. What if it where through a utility loss or a death probability increase (change in discount rate)? I suspect there is a reasonable specification that could reverse the result. I want to see a paper that proves me wrong.


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