Working Paper: NBER ID: w28712
Authors: Georgii Riabov; Aleh Tsyvinski
Abstract: The paper develops a general methodology for analyzing policies with path-dependency (hysteresis) in stochastic models with forward looking optimizing agents. Our main application is a macro-climate model with a path-dependent climate externality. We derive in closed form the dynamics of the optimal Pigouvian tax, that is, its drift and diffusion coefficients. The dynamics of the present marginal damages is given by the recently developed functional Itô formula. The dynamics of the conditional expectation process of the future marginal damages is given by a new total derivative formula that we prove. The total derivative formula represents the evolution of the conditional expectation process as a sum of the expected dynamics of hysteresis with respect to time, a form of a time derivative, and the expected dynamics of hysteresis with the shocks to the trajectory of the stochastic process, a form of a stochastic derivative. We then generalize the results. First, we propose a general class of hysteresis functionals that permits significant tractability. Second, we characterize in closed form the dynamics of the stochastic hysteresis elasticity that represents the change in the whole optimal policy process with an introduction of small hysteresis effects. Third, we determine the optimal policy process.
Keywords: stochastic models; hysteresis; climate externalities; Pigouvian tax
JEL Codes: E0; H23; Q4; Q5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Optimal Pigouvian tax (H21) | Marginal externality damages (D62) |
| Current emissions (Q52) | Marginal externality damages (D62) |
| Historical trajectory of emissions (N71) | Marginal externality damages (D62) |
| Past emissions decisions (Q52) | Future policy outcomes (D78) |
| Current policies (J18) | Future consequences (D15) |
| Marginal damages from emissions (Q52) | Path-dependent effects (D91) |