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This paper studies the role of expectations and monetary policy in the economy's response to climate actions. We show that in a stochastic environment, without the standard assumption of the perfect rationality of agents, there is more uncertainty regarding the path and the economic impact of a climate policy, with a potential threat to the ability of central banks to maintain price stability. Market beliefs and behavioral agents increase the trade-offs inherent to the chosen mitigation tool, with a carbon tax entailing more emissions uncertainty than in a rational expectations model and a cap-and-trade scheme implying a more pronounced pressure on allowance prices and inflation. The impact on price stability is worsened by delays in the implementation of stringent climate policies, the lack of confidence in the ability of central banks to keep inflation under control, and the adoption of monetary rules tied to expectations rather than current macroeconomic conditions. Central banks can implement successful stabilization policies that reduce the uncertainty surrounding the impact of climate actions and support the greening process while remaining within their mandate. • This work investigates how expectations can shape a green transition. • Without fully rational agents impacts of climate policy are more uncertain. • Carbon taxes and cap-and-trade's drawbacks are enlarged by non-fully-rational agents. • Delayed action and low credibility in central banks cause major inflationary pressure. • A reactive monetary policy can reduce uncertainty on climate policies' impacts. [ABSTRACT FROM AUTHOR]

• We present a behavioural New Keynesian model with different beliefs. • Economic fluctuations may be driven by heterogeneous expectations. • Credit cycles and inequalities in the distribution of wealth emerge endogenously. • With limits on the amount of borrowing the model generates severe crises. • Monetary policy can reduce the frequency of severe recessions. In a behavioral variant of a New Keynesian model, in which individuals use simple heuristic rules to forecast future inflation and output, if there are limits on the amount of debt that economic agents are allowed to bear, we observe occasionally severe downturns. Differences in beliefs combined with borrowing constraints tend to dampen expansions, but give rise to a chain reaction that exacerbates the recessions. The model is an example of endogenous credit cycles with expansions, severe recessions, and persistent inequality in the distribution of wealth. Monetary policy can both stabilize the economy and cause increased average output. [ABSTRACT FROM AUTHOR]

Abstract: In the context of the current policy debate on the reform of European fiscal rules, there is wide consensus on the need to place more attention on debt–GDP ratios. Proposals have been made to alleviate fiscal pressure on Member States with relatively low public debts. The present paper gives support to this view. Economies with high public debt–GDP ratios are shown to experience larger price deviations after a fiscal expansion. These results are derived in a model, calibrated to euro area quarterly data, with capital accumulation, flexible prices and wealth effects in the presence of an independent monetary authority. [Copyright &y& Elsevier]