Environmental degradation and inflation in high-income countries

Keeping inflation on track and combatting environmental degradation has risen ever higher on the policymaking agenda. We investigate the impact of inflation on CO₂ emissions by taking advantage of a novel dataset comprising 28 high-income countries from 1996 to 2021. We employ a unique amalgam of estimation methods ranging from regressions at the mean that account for slope heterogeneity and cross-sectional dependence, quantile estimators, Cholesky impulse response functions (IRFs) using flexible local projections and a New Keynesian (NK) model with environmental externalities to confirm robustness. Our findings point to a positive and significant association between inflation and carbon emissions along with a negative effect of financial depth on carbon emissions, thereby providing strong incentive for policymakers to bring inflation back down to the target and enhance financial development in order to avert environmental degradation. These impacts appear to be heterogeneous across country groupings, with generally larger impacts in low inflation countries. By disentangling the inflation drivers, the evidence suggests that energy inflation is the primary driver of CO₂ emissions with implications for the setting of monetary policy.