Fossil fuels, alternative energy and economic growth

Abstract

We present a theoretical framework that incorporates energy within an endogenous growth model. The model explicitly allows for the interaction and substitution between fossil fuels, defined as a non-renewable resource derived from some fixed initial stock, and alternative energy, defined as renewable resource whose production requires capital input. The dynamics of the model depict a unique balance growth to a steady state. The saddle path of consumption temporarily peaks, when fossil fuels are plentiful and cheap, followed by a fall, as fossil fuel become more scarce and alternative energy production has yet to take over, until finally the steady state is reached where alternative energy production fuels the entire economy. The model demonstrates the dynamic substitution of depleting fossil fuel with renewable alternative energy such as to mitigate the negative consequences on growth and welfare of an ever-depleting fuel source in an energy dependent economy. Alternative energy and its potential productivity growth relative to fossil fuels also extends the period of low extraction rates and thereby keeping the finite resource in the ground for longer. The analysis is based on continuous time dynamic simulations that allow for the explicit consideration of transitional dynamics. In particular, the approach highlights the possible short run and medium run non-monotonic paths of consumption, investment and growth, whose analysis are necessarily lost when considering either the steady state equilibrium or deviations from it.