DEMOGRAPHICS, PRODUCTIVITY GROWTH AND THE MACROECONOMIC EQUILIBRIUM

Abstract

I. INTRODUCTION The demographics in the United States are, as in other industrial countries, experiencing drastic changes. The birth rate is falling while life expectancy is rising. As a consequence, the ratio of the elderly to the working-age population is projected to rise sharply in the next fifty years. The aging of the population imposes both real and imagined burdens on the economy (Aaron [1990]). Most importantly, it is predicted to cause substantial increases in the tax rates needed to sustain existing social security benefits, thereby bringing about an increase in conflict between the working and the elderly generations (Wildasin [1991], Von Weizsacker [1990] and Verbon [1988]). Population aging also means it is more likely that the pay-as-you-go system of financing social security will be dynamically inefficient (Hu [1993]). In this case, the economy is better served by switching to another financing system. Indeed, a number of countries, most notably Chile, have chosen to privatize their state pension systems. More broadly, there is evidence that the changing age distribution in the U.S. population has significantly affected consumption, housing investment, money demand and the labor-force participation rate (Fair and Dominguez [1991]), and is potentially very important for explaining the U.S. rate of national saving for the next fifty years (Auerbach and Kotlikoff [1990]). It also affects capital accumulation by causing changes in family insurance and intergenerational trade (Ehrlich and Lui [1991]). Existing studies of the economic effects of demographics assume either that both work hours and retirement behavior are exogenous, or that work hours are endogenous but retirement behavior is exogenous. For example, Cutler, Poterba, Sheiner and Summers [1990] model the labor-market effects of population aging by imposing the projected age distributions on the current labor-force participation rates across age cohorts, rather than on those corresponding to the projected demographics. As such, they implicitly assume exogenous work hours and concentrate on the age-distribution effect of population aging. Auerbach and Kotlikoff [1990] set an exogenous retirement age of sixty-five although they allow endogenous determination of work hours. Feldstein [1980] provides evidence that incorporation of induced retirement improves the prediction of how social security affects capital accumulation. Likewise, studies of the effects of demographic changes and their interactions with social security will be more fruitful if retirement decisions are explicitly recognized. This is particularly true since the 1983 Amendment to the Social Security Act would gradually relax the retirement test, thus removing the distortions that prevent retirement decisions from adjusting to changing demographics. This paper provides a computational study of the effects of demographics on the macroeconomic equilibrium and welfare within the framework of an intertemporal optimizing model with age heterogeneity and endogenous productivity growth. The model extends Tobin [1967] and Cass and Yaari [1967] to allow for endogenous retirement decisions. It differs from Hu [1978; 1993] in that it incorporates endogenous productivity growth. A key feature that differentiates this analysis from previous studies is that retirement decisions are characterized by a binary choice of whether to work or not to work, but work hours are exogenous during working years.(1) To facilitate comparisons, we also provide a simulation which shows what would happen if social security provisions were such as to prevent the retirement age from adjusting to the demographic changes. To study the effects of demographics on the macroeconomic equilibrium involves explaining their effects on the labor-force participation rate and aggregate consumption, their interactions with social security, and their implications for the welfare of the economy. …