Effects on growth of environmental policy in a small open economy

This paper examines the effect of environmental policy on economic growth in a small open economy in a neoclassical framework with pollution as an input. We show that environmental policy imposes a drag on long run growth in both the open and closed economy cases. The effect of environmental policy on growth is stronger in the open economy case relative to the closed economy model if the country has strong aversion to pollution and thus serves as a net exporter of capital in the international capital market. On the other hand, if the agents in the economy have low aversion to pollution and thus import capital, the effect of environmental care on growth is stronger in the closed economy relative to the open economy. Thus, from our set-up, environmental policy is harmful to growth but environmental sustainability need not be incompatible with continued economic growth.