The Climate change increases the risks to financial stability across economies, by exposing economic activity, assets and capital flows to exogenous shocks. This paper argues for “Circular Monetary Economics”, an approach to monetary policy that seeks to green and prudentially insulate the design and implementation of liquidity and credit facilities. Central banks repo market operations and liquidity infusions occasion a structural liquidity mismatch in financial markets, but could be sued to incentivise the transition towards a greener economy. By aligning credit growth and standards with central bank liquidity, commercial banks will be incentivised to green and insulate their portfolios against extreme climate events. Circular monetary economics will lessen the probability of cross-asset contamination within financial institutions and contagion within the broader financial system, whilst simultaneously improving the transmissions from changes in the policy rate as well as macro-prudential regimes in the event of a climate or credit-driven financial shock.
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