Some credit booms, though by no means all, result in financial crises. While risk-taking incentives seem a plausible cause, market participants do not appear to anticipate increasing risk. We show how credit expansions driven by credit supply shocks may be misunderstood as productivity driven, due to the opacity of bank balance sheets. Large funding shocks may induce some intermediaries to scale up speculative lending, distorting price signals. Other banks and firms may misjudge actual profitability, reinforcing the credit expansion. Similarly, at times of low saving supply credit may be inefficiently low, and speculative assets underpriced.
We analyze jointly optimal carbon pricing and financial policies under financial constraints and endogenous climate-related transition and physical risks. The socially optimal emissions tax may be above or below a Pigouvian benchmark, depending on whether physical climate risks have a substantial impact on collateral values. We derive necessary conditions for emissions taxes alone to implement a constrained-efficient allocation, and show a cap-and-trade system or green subsidies may dominate emissions taxes because they can be designed to have a less adverse effect on financial constraints. Additionally introducing leverage regulation can be welfare-improving if environmental policies have a direct negative effect on financial constraints. Furthermore, our analysis highlights the positive effect of carbon price hedging markets on equilibrium environmental policies.
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