Greenflation: The cost of the green-transition in small open economies

Abstract

We propose a new model of a small open economy with efficient energy use to investigate the inflationary dynamics along the green transition. The model incorporates the production of green energy that substitutes exogenous brown energy sources in production. Production is characterized by substitutability between the resource and other inputs that firms can alter though directed input-saving technical change. We investigate the dynamics of the green transition induced by either exogenous increases of brown energy prices and/or policy changes in the brown energy taxation; green subsidies and green public investment. Increases in brown energy prices and taxes decrease the usage of brown energy but do not expand significantly the green sector, they simply improve energy efficiency use, surging firm's marginal costs leading to greenflation and output losses. Green subsidies and public investment effectively increase the usage of green energy but imply a slower transition with no significant output and inflation costs and but with no improvements in efficient energy usage. The systematic reaction of monetary policy affects the transitional inflation dynamics.