Abstract:

This paper develops and estimates a dynamic general equilibrium model of the global economy to investigate how imperfect and gradual adjustments of capital and labor across sectors affect the effectiveness of climate policies in reducing global emissions. The model’s estimates indicate that both capital assets and workers exhibit low responsiveness to changes in climate policies, limiting the policies’ ability to permanently and swiftly shift capital and labor out of the sector that extracts and processes raw fossil fuels. I demonstrate that a counterfactual subsidy implemented by China on non-fossil fuel energy sources would boost consumption and investment in the targeted sector but may inadvertently raise global emissions due to increased aggregate output and investment. Imperfect factor mobility amplifies this effect by limiting the
reallocation of capital and labor away from the sector that produces fossil fuels. My findings underscore the need to (i) combine a subsidy on non-fossil fuel energy sources with a carbon tax and (ii) improve capital and labor mobility to both reduce global emissions and enhance aggregate consumption.