The green metamorphosis of a small open economy

Abstract

We design a canonical model of green transition for a small open economy with endogenous energy efficiency. Production combines energy and traditional factors with low short-run substitutability and efficient technology adoption. Increases in brown energy taxation reduce brown energy usage and improve energy efficiency in the long run but lead to an increase in firms’ marginal costs with inflationary effects and persistent output losses in the short run. Green public investment or subsidies induce a transition with no inflationary or output costs but with no energy efficiency improvements and no significant reduction in brown energy usage unless they increase substantially, exerting considerable fiscal pressure. Evaluating welfare along the transition, we show that policies that combine subsidies or public investment with carbon taxes can reduce the costs of the green transition.