Climate Policies, Macroprudential Regulation, and the Welfare Cost of Business Cycles

We study how alternative carbon pricing policies, namely carbon taxes and cap-and-trade schemes, affect macroeconomic dynamics and the welfare cost of business cycles in a dynamic stochastic general equilibrium model with financial frictions (FFs) and pollution externalities. FFs play a critical role in shaping how business cycle shocks propagate across carbon pricing regimes. We find that, with financial frictions, welfare costs are generally lower under cap-and-trade schemes than under carbon taxes, as procyclical permit prices dampen financial amplification. The welfare gap between the two policies narrows as credit markets become more efficient or countercyclical macroprudential regulation weakens shock transmission.