Interest Rates and Environmental Pollution

By Rashid, Muhammad; Sharma, Basu | Journal of Comparative International Management, June 2008 | Go to article overview

Interest Rates and Environmental Pollution


Rashid, Muhammad, Sharma, Basu, Journal of Comparative International Management


While there is a growing body of theoretical and empirical literature examining the effects of such macroeconomic variables as growth of gross domestic product, international trade, incomes distribution and foreign direct investment oil environmental pollution, one dimension lacking ill the current literature is the impact of interest rates on pollution. If interest rates decline (rise), firms with capital intensive technologies will invest more (less) relative to firms with labor intensive technologies. Additionally,. according to Rybczynski theorem, in a situation of full employment and a competitive labour market, labor will shift towards the capital-intensive industries from labor--intensive ones. Consequently, the products of capital-intensive industries will expand (contract) relative to products of labor intensive industries. The capital-intensive industries are generally deemed to be polluting while labor-intensive industries are perceived to he non-polluting. This suggests that the movements of interest rates may have a discernible environmental outcome which has been neglected in the literature so far. To begin to fill this gap. in this paper, we construct a two-good and two-factor closed economy model to show the impact of interest rates on environmental pollution in a formal way. The theoretical results of the paper are illustrated numerically.

1. Introduction

One of the key problems pervasive across societies today is an increasing level of environmental pollution. How to reduce or control it has become the preoccupation of policymakers in many societies. There is a growing body of theoretical and empirical literature examining the effects of such macroeconomic variables as growth of gross domestic product, international trade, incomes distribution and foreign direct investment on environmental pollution. However, one important dimension lacking in the current literature is the effect of interest rate on pollution. The objective of this paper is to begin to fill in this gap by developing a model to analyze effects of interest rate on environmental pollution.

Section one of the paper presents a brief overview of relevant literature to provide for a theoretical grounding of the study. Section two develops a model linking pollution to capital stock. Section three will provide the comparative static results with respect to changes in interest rates, together with hypotheses of the model. A numerical example of the model is provided in Section four. In the final section, we summarize our main results, derive policy implications of the results and make suggestion for further research.

2. Theoretical Underpinnings

The literature on environment is multi-faceted and diverse. There is physical side of pollution--that is, how does pollution arise? And papers in this context have identified the contamination of air, water and soil. Within each source of pollution, a series of causes of pollution have been identified. For example, with respect to air pollution, the main sources are suspended particulates, lead, sulfur-dioxide, carbon dioxide, nitrogen dioxide and ozone. And an estimate suggests that sixty-seven percent of air pollution arises from road transportation and industrial activities.

The physical aspects of pollution involve issues such as acid rain and global warming and possible alternatives to each type of pollution but they do not focus on cost-benefit analysis. The cost-and-benefit analysis or economic approach to pollution has involved both micro and macro dimensions. At the micro level, the literature focuses on property rights and environmental externalities (Rauch, 2005; Solakoglu, 2007), project evaluation (Tol and Lyons, 2008), the estimation of social cost of pollution (Pearce, 2003), and economics of emission changes, marketable permits and carbon pollution taxes (Taiyab, 2006; Brown and Corbera, 2003).

The literature that has focused on macro-economic, political, social and globalization issues arising from the environmental pollution has been more voluminous. …

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