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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]

Limiting global warming to well below 2 °C may pose threats to macroeconomic and financial stability. In an estimated Euro Area New Keynesian model with financial frictions and climate policy, we study the possible perils of a low-carbon transition and evaluate the role of monetary policy and financial regulation. We show that, even for very ambitious climate targets, transition costs are moderate along a timely and gradual mitigation pathway. Inflation volatility strongly increases for disorderly climate policy, demanding a strong monetary response by central banks. In reaction to an adverse financial shock originating in the fossil sector, a green quantitative easing policy can provide an effective stimulus to the economy, but its stabilizing properties do not significantly differ from those of market neutral asset purchase programs. A financial regulation, encouraging the decarbonization of the banks' balance sheets via ad hoc capital requirements, can significantly reduce the severity of a financial crisis, but prolongs the recovery phase. Our results suggest that the involvement of central banks in climate actions must be carefully designed to be in compliance with their mandate and to avoid unintended trade-offs. • We develop a New Keynesian model with climate policy and financial frictions. • We study the role of financial regulation and monetary policy in a green transition. • The risk of macro-financial instability is limited for a gradual mitigation pathway. • Green quantitative easing programs stabilize the economy after a financial shock. • Differentiated capital requirements can mitigate the severity of a financial crisis. [ABSTRACT FROM AUTHOR]