Environmental policy and macroeconomic dynamics in a new Keynesian model

•In a New Keynesian model we study the behavior of an economy under different environmental policy regimes.•A cap-and-trade policy tends to dampen macroeconomic fluctuations.•Price stickiness is found to affect the performance of the chosen environmental policy regime.•The optimal environmental policy response to shocks depends on price stickiness and on the monetary-policy conduct.

This paper studies the dynamic behavior of an economy under different environmental policy regimes in a New Keynesian model with nominal and real uncertainty. We find the following results: (i) an emissions cap policy is likely to dampen macroeconomic fluctuations; (ii) staggered price adjustment alters significantly the performance of the environmental policy regime put in place; (iii) the optimal environmental policy response to shocks is strongly influenced by the degree to which prices adjust and by the monetary policy reaction.