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Effects of Macroeconomic Policy on Air Quality in the US

This research examines the impact of expansionary macroeconomic policy on air quality in the US. It analyzes the relationship between fiscal and monetary policy and pollution levels using vector autoregression methods. The study explores the effects on production- and consumption-generated sources of pollution.

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Effects of Macroeconomic Policy on Air Quality in the US

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  1. Effects of macroeconomic policy on air quality: Evidence from the US • Prof. George Halkos & Epameinondas Paizanos • Lab of Operations Research, Dept of Economics University of Thessaly • Οικονομική των Φυσικών Πόρων και του Περιβάλλοντος: Κλιματική Αλλαγή • 2ο Πανελλήνιο Συνέδριο • Volos, 31 October - 01 November 2014 • This research has been co-financed by the European Union (European Social Fund – ESF) and Greek national funds through the Operational Program "Education and Lifelong Learning" of the National Strategic Reference Framework (NSRF) - Research Funding Program: Heracleitus II. Investing in knowledge society through the European Social Fund. Prof. George E. Halkos & Epameinondas A. Paizanos 1

  2. Introduction • Expansionary macroeconomic policy has been employed in many countries to alleviate the adverse effects of the 2008-2009 economic crises. • A large fraction of national GDP is spent by governments affecting a variety of economic variables and wealth in general,while a recent strand of literature suggests that government spending is an important determinant of environmental quality (Lopez et al., 2011, Halkos and Paizanos, 2013; Galinato and Islam, 2014). • In addition, historically low levels of interest rates have been set. • The relationship between macroeconomic policy and pollution has not been studied extensively in the literature. Prof. George E. Halkos & Epameinondas A. Paizanos 2

  3. Introduction (cont’d) • According to Lopez et. al. (2011) there are four mechanisms through which level and composition of fiscal spending may affect pollution levels: • Scale effect (increased environmental pressures due to economic growth), • Composition effect (increased human capital intensive activities instead of physical capital intensive industries that harm environment more), • Technique effect (due to higher labor efficiency) • Income effect (increased income raises demand for improved environmental quality).

  4. Introduction (cont’d.) • Our paper is the first to examine the effects of both fiscal and monetary policy on pollution. • Use of Vector Autoregression Methods • Examine the effects on production- and consumption-generated sources of pollution. Prof. George E. Halkos & Epameinondas A. Paizanos 4

  5. Data • 12 macroeconomic and environmental variables. Quarterly data for the period 1973-2013, for the US economy. 164 observations per variable. • The macroeconomic variables used are GDP, Private Consumption, Total Government Expenditure, Total Government Revenue, Real Wages, Private Non-Residential Investment, Interest Rate, Adjusted Reserves, PPIC and GDP deflator • Based on the sources of pollution, CO2 emissions may be distinguished between production-generated (i.e. from industrial sources) and consumption–generated (i.e. from residential and transport sources). Prof. George E. Halkos & Epameinondas A. Paizanos 5

  6. Data Prof. George E. Halkos & Epameinondas A. Paizanos 6

  7. Methodology • A typical Vector Autoregression Model may be presented as where Ztis a vector that contains the system variables; β1, β2, ….βp are parameters; α is the deterministic element of the VAR model; et is the vector of random errors distributed with zero mean and Ω variance matrix. 7 Prof. George E. Halkos & Epameinondas A. Paizanos

  8. Methodology (cont’d) • If the variables are non-stationary but are integrated of order 1 [i.e. I(1)] and co-integrated then a Vector Error Correction Model (VECM) should be estimated instead. • The VECM has cointegration relations built into the specification so that it restricts the long-run behavior of the endogenous variables to converge to their co-integrating relationships while allowing for short-run adjustment dynamics. • Generalized Impulse Responses are constructed that do not require orthogonalization of shocks, thus the resulting impulse responses are invariant to the ordering of the variables in the VAR giving robust results. Prof. George E. Halkos & Epameinondas A. Paizanos 8

  9. Methodology (cont’d) • Three main issues which typically arise in the identification of fiscal policy shocks in VAR models. • Distinguishing movements in fiscal variables caused by fiscal policy shocks from those which are simply the automatic movements of fiscal variables in response to other shocks  Identify a business cycle shock and a monetary policy shock and require that a fiscal shock be orthogonal to both of them • What one means by a fiscal policy shock  Macroeconomic fiscal policy shocks exist in a two dimensional space spanned by a government revenue shock and a government spending shock. • There is often a lag between the announcement and the implementation of fiscal policy and that the announcement may cause movements in variables before there are movements in the fiscal variables.  We identify fiscal policy shocks with the identifying restriction that the fiscal variable in question does not respond for four quarters, and then changes for a defined period afterwards. Prof. George E. Halkos & Epameinondas A. Paizanos 9

  10. Results • CO2IC is Granger caused by government expenditure, government revenue and GDPc. • CO2RTC is Granger caused only by government revenue. Prof. George E. Halkos & Epameinondas A. Paizanos 10

  11. Results (cont’d) All variables are I(1) Prof. George E. Halkos & Epameinondas A. Paizanos 11

  12. Results (cont’d) • The trace statistic indicates 3 cointegrating equations, while the maximum eigenvalue statistic indicates 1 cointegrating equation. Hence, following the most conservative statistic, we estimate the VECM assuming 1 cointegrating equation. • Performance of the AIC and SC criteria combined with an application of the Portmanteau Autocorrelation Test showed that the preferable length of lags for the model is 2. Prof. George E. Halkos & Epameinondas A. Paizanos 12

  13. Results (cont’d) Prof. George E. Halkos & Epameinondas A. Paizanos 13

  14. Results (cont’d) • An 1 S.D. increase of government expenditure leads to a decline of production generated CO2 emissions which reaches a peak of -0.012 in 6 quarters and then is stabilized at about -0.011. • On the other hand, an 1 S.D. shock of government revenues reduces production generated CO2 emissions which reaches a maximum of -0.008 after 2 quarters. However, from the 5th quarter onwards this effect is not statistically significant. • Following an increase of the interest rate, CO2IC slightly increases on impact and then begins to decline after the 10th quarter stabilizing at -0.012. • CO2IC starts increasing after a positive shock in income but this effect is significant only until the 3rd quarter. Prof. George E. Halkos & Epameinondas A. Paizanos 14

  15. Results (cont’d) Prof. George E. Halkos & Epameinondas A. Paizanos 15

  16. Results (cont’d) • Regarding consumption generated CO2 emissions, an 1 S.D. increase of government expenditure has no effect, while the same is also holds for a shock in government revenue, monetary policy and per capita income. • According to forecast error variance decomposition analysis government expenditure explains more than 15% of CO2IC emissions fluctuations, while only 1% of CO2RTC variability. Government revenue shocks explain about 4.5% and 1.9% of the fluctuations in CO2IC and CO2RTC respectively. Finally, monetary policy shocks explain around 10% of CO2IC and 5% of CO2RTC fluctuations . Prof. George E. Halkos & Epameinondas A. Paizanos 16

  17. Results (cont’d) Realistic fiscal policy scenarios • We analyse three key policy scenarios below: deficit spending, a deficit-financed tax cut and a balanced budget spending expansion. • We view different fiscal policy shocks as different linear combinations of the basic fiscal policy shocks, namely a government expenditure shock and a government revenue shock. There are clearly a huge number of possible fiscal policies we could analyze, so here we focus on comparing three popularly analyzed fiscal policies. Prof. George E. Halkos & Epameinondas A. Paizanos 17

  18. Results (cont’d) • The tax cut initially decreases CO2IC emissions but starting from the 5th quarter and until the 20 quarter production- generated pollution significantly increases. • For CO2RTC there is a reduction on impact and on the 1st quarter, however there is a significant positive impact from the 5th to the 21st quarter. Prof. George E. Halkos & Epameinondas A. Paizanos 18

  19. Results (cont’d) • The deficit spending scenario reduces production and consumption generated CO2 emissions during the first seven and three quarters respectively, however the effect is much smaller in the latter. Prof. George E. Halkos & Epameinondas A. Paizanos 19

  20. Results (cont’d) • There is a relatively important reduction effect on impact for both production and consumption generated pollution which lasts until the 12th and 16th quarters respectively and then ceases to be significant. Prof. George E. Halkos & Epameinondas A. Paizanos 20

  21. Results (cont’d) Prof. George E. Halkos & Epameinondas A. Paizanos 21

  22. Conclusions • Our results confirm the theoretical and empirical developments on the existence of a correlation between fiscal policy and pollution, as well as provide for the first time evidence regarding the relationship between monetary policy and environmental degradation. • Estimation of a non-positive effect of government spending on production-generated pollution is in line with recent findings by Lopez et al. (2011), Lopez and Palacios (2010) and Halkos and Paizanos (2013). • On the other hand, a deficit-financed tax cut policy decreases CO2IC and CO2RTC emissions in the short-run, but the estimated impact is positive thereafter. • Monetary policy only has an effect on production-generated pollution. Prof. George E. Halkos & Epameinondas A. Paizanos 22

  23. Conclusions (cont’d) • The difference in magnitude and significance between the estimated effect of government expenditure on CO2IC and CO2RTC could be explained by the mechanisms through which the different types of pollutants respond to certain policies. • In particular, the regulation of production-generated pollutants is expected to be more straightforward and this is reflected in the estimated effects. Prof. George E. Halkos & Epameinondas A. Paizanos 23

  24. Conclusions (cont’d) • Given our results, the expansion of government spending may have an unexpected effect: it could make reducing pollution easier to achieve entailing much lower costs than what is usually assumed. • This implication is particularly important because even if environmental regulation remains unchanged, the change in the size and composition of government spending towards public goods is likely to reduce, mainly, production- but also consumption-generated pollution. • Finally, regarding production-generated pollution, the analysis has shown that there is also a possibility to use monetary policy to mitigate environmental degradation. Prof. George E. Halkos & Epameinondas A. Paizanos 24

  25. Thank you for your attention! Prof. George E. Halkos & Epameinondas A. Paizanos 25

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