Simple OLG Research Articles

Are deficits free?

Deficit finance, a.k.a. pay-go policy, is free when growth rates routinely exceed safe government borrowing rates. Or so many say. This note presents four counterexamples based on four versions of a simple OLG economy. In each version the growth rate exceeds the safe rate for one of four reasons – uninsured idiosyncratic risk, uninsured aggregate risk, policy uncertainty, and imperfect financial intermediation. Deficit finance does not directly address any of these problems. What works, respectively speaking, is progressive taxation, bilateral intergenerational risk-sharing, early policy resolution, and improved intermediation. The four examples thus show that seemingly free deficits may be more costly than they appear. Indeed, inefficient pay-go policy can even lower the government’s borrowing rate, encouraging yet more deficit finance.

Will the Paris Accord Accelerate Climate Change?

The 2015 Paris climate accord (Paris Agreement) is meant to control our planet’s rising temperature to limit climate change. But it may be doing the opposite in permitting a slow phase-in of CO2 emission mitigation. The accord asks its 195 national signatories to specify their emission reductions and to raise those contributions over time. However, there is no mechanism to enforce these pledges. This said, the accord puts dirty energy producers on notice that their days are numbered. Unfortunately, this “use it or lose it” message may accelerate the extraction and sale of fossil fuels and, thereby, permanently worsen climate change. Our paper uses a simple OLG model to illustrate this long-noted, highly troubling Green Paradox. Its framework properly treats climate damage as a negative externality imposed by today’s generations on tomorrow’s—an externality that is, in part, irreversible and, if large enough, can tip the climate to a permanently bad state. Our paper shows that delaying abatement can be worse than doing nothing. Indeed, it can make all generations worse off. In contrast, immediate policy action can make all generations better off. Finally, we question the standard use of infinitely lived, single-agent models to determine optimal abatement policy. Intergenerational altruism underlies such models. But its assumption lacks empirical support. Moreover, were such altruism widespread, effective limits on CO 2 emissions would, presumably, already be in place. Unfortunately, optimal abatement prescriptions derived from such models can differ, potentially dramatically, from those actually needed to correct the negative climate externality that today’s generations are imposing on tomorrow’s.

Correction to: Mortality, fertility, education and capital accumulation in a simple OLG economy

Correction to: Mortality, fertility, education and capital accumulation in a simple OLG economy

Borrowing constraints and saving in Turkey

The Turkish macroeconomic experience since 2002 has been characterized by three striking trends: (1) an accelerated growth rate of income, (2) a sharp decline in the real interest rate, and (3) a sustained fall in the saving rate of different age-groups. During the same period, there has also been a significant increase in access to credit by Turkish households. In this paper, we argue that a model which incorporates a borrowing constraint mechanism together with the observed increases in the expected growth rate of income and the substantial declines in the real interest rate is able to explain the change in saving across cohorts in Turkey over the last decade. We provide both micro-level evidence on the age-saving profile for Turkey as well as quantitative results from a simple three-period OLG framework with borrowing constraints to account for the change in the saving rate for different age-groups between 2004 and 2014.

Demographics and FDI: Lessons from China's One-Child Policy

Lucas (1990) argues that the neoclassical adjustment process fails to explain the relative paucity of FDI inflows from rich to poor countries. In this paper we consider a natural experiment: using China as the treated country and India as the control, we show that the dynamics of the relative FDI flows subsequent to the implementation of China's one-child policy, as seen in the data, are consistent with neoclassical fundamentals. In particular, following the introduction of the one-child policy in China, the capital-labor (K/L) ratio of China increased relative to that of India, and, simultaneously, relative FDI inflows into China vs. India declined. These observations are explained in the context of a simple neoclassical OLG paradigm. The adjustment mechanism works as follows: the reduction in the (urban) labor force due to the one-child policy increases the savings per capita. This increases the K/L ratio and reduces the marginal product of capital (MPK). The reduction in MPK (relative to India) reduces the relative attractiveness of investment in China and is thus associated with lower FDI/GDP ratios. Our paper contributes to the nascent literature exploring demographic transitions and their effects on FDI flows.

Vested Interest And Resistance To Technology Adoption

Employed technologies differ vastly across countries.Within countries many technologies that would obviously improve firms' efficiency are not adopted. This paper explains these observations by emphasizing that a new technology positively affects workers by lowering prices and increasing their real income, but also negatively by costs of getting acquainted with the new technology. If the costs of adoption for workers exceed the benefits, they will aim at keeping the old technology in place. We formalise the trade-off in a simple OLG model with majority voting. Age groups that lose from adopting resist. Successful resistance blocks adoption and hence lowers growth. Finally, we analyse the effects of tougher competition. Provided that consumption and leisure are relatively good substitutes, tougher competition mitigates resistance and thus favours economic growth as it increases the share of the rent associated with the new technology that is being captured by the workers.

Population Ageing and Capital Accumulation: A Simple OLG Model with PAYGO Pensions

Population in developed countries has dramatically aged in recent years. At the same time, most of these countries finance their old-age public pension benefits on a pay-as-you-go (PAYGO) basis. Such a pension scheme combined with an ageing population, represent a financial challenge for the governmental budgets. Accordingly, several studies have been done on the effects of population ageing. In the present paper, the purpose is to study how population ageing will affect capital accumulation. A simple OLG model with PAYGO pension is applied. The formulation of the model makes it possible to deduce an explicit expression for this relation. It is shown that an increase in the elderly dependency ratio will increase the long-run capital stock.

The Relevance or Otherwise of the Central Bank's Balance Sheet

This paper explores the impacts on an economy of a central bank changing the size and composition of its balance sheet. One of the ways in which such asset purchases could influence prices and demand is via portfolio balance effects. We develop and calibrate a simple OLG model in which risk‐averse households hold money and bonds to insure against risk. Central bank asset purchases have the potential to affect households’ choices by changing the composition and return of their asset portfolios. We find that the effect is weak, and that its size depends on how fiscal policy is conducted. That is not to say that the big expansion of central bank balance sheets in recent years has been ineffective. Our finding is rather that the portfolio balance channel evaluated in an environment of normally functioning (though nonetheless incomplete) asset markets is weak. That is not inconsistent with the evidence that large‐scale asset purchases by central banks since 2008 have had significant effects, because those purchases were made when financial markets were, to varying extents, dysfunctional. Nonetheless our results are relevant to those purchases because they may be unwound in an environment where financial markets are no longer dysfunctional.

The relevance or otherwise of the central bank's balance sheet

This paper explores the impacts on an economy of a central bank changing the size and composition of its balance sheet. One of the ways in which such asset purchases could influence prices and demand is via portfolio balance effects. We develop and calibrate a simple OLG model in which risk-averse households hold money and bonds to insure against risk. Central bank asset purchases have the potential to affect households' choices by changing the composition and return of their asset portfolios. We find that the effect is weak, and that its size depends on how fiscal policy is conducted.That is not to say that the big expansion of central bank balance sheets in recent years has been ineffective. Our finding is rather that the portfolio balance channel evaluated in an environment of normally functioning (though nonetheless incomplete) asset markets is weak. That is not inconsistent with the evidence that large-scale asset purchases by central banks since 2008 have had significant effects, because those purchases were made when financial markets were, to varying extents, dysfunctional. Nonetheless our results are relevant to those purchases because they may be unwound in an environment where financial markets are no longer dysfunctional.

The Relevance or Otherwise of the Central Bank's Balance Sheet

This paper explores the impacts on an economy of a central bank changing the size and composition of its balance sheet. One of the ways in which such asset purchases could influence prices and demand is via portfolio balance effects. We develop and calibrate a simple OLG model in which risk-averse households hold money and bonds to insure against risk. Central bank asset purchases have the potential to affect households' choices by changing the composition and return of their asset portfolios. We find that the effect is weak, and that its size depends on how fiscal policy is conducted. That is not to say that the big expansion of central bank balance sheets in recent years has been ineffective. Our finding is rather that the portfolio balance channel evaluated in an environment of normally functioning (though nonetheless incomplete) asset markets is weak. That is not inconsistent with the evidence that large-scale asset purchases by central banks since 2008 have had significant effects, because those purchases were made when financial markets were, to varying extents, dysfunctional. Nonetheless our results are relevant to those purchases because they may be unwound in an environment where financial markets are no longer dysfunctional.

Auswirkungen einer Einbeziehung der Selbständigen in die Gesetzliche Rentenversicherung

This study analyses the theoretical and empirical effects of an inclusion of self-employed persons in the German Pension System. First, the theoretical consequences for the contribution rate are analyzed using a simple OLG model. Second, the implications for the contribution rate are simulated for different scenarios using the pension simulation model MEA-Pensim. It appears that in the short and middle run the inclusion of the self-employed persons leads to a reduction of the contribution rate. The degree of this temporary effect depends essentially on the assumed contribution assessment basis, the size and characteristics of the included group of people (all self-employed persons or only the self-employed persons without employees), and the age at which for older currently self-employed persons a preservation of the status quo will be established (inclusion of self-employed persons under the age of 50 or the age of 30). The maximal contribution rate effect arises with 1.3 percent points by including all self-employed persons with the net income as contribution basis. In this case the standard pension level would be 2.1 percent points higher. In the long run (until 2060) and independently of the underlying assumptions the contribution rate reaches the same level compared to a status quo scenario where the self-employed persons are still exempt. Given a higher life expectancy for the self-employed their inclusion increases the contribution rate slightly in the long run. In terms of people who are already insured by the German pension system the reform has positive effects with regard to efficiency. Furthermore the equal treatment between generations improves for those who are already insured.

Intergenerational redistribution and risk sharing with changing longevity

Trend increases in longevity are a global phenomenon challenging the fiscal sustainability of current welfare arrangements. Policy proposals abound and often build on implicit assertions concerning intergenerational equity. This paper offers a simple but manageable OLG model with endogenous retirement and cohort-specific longevity to address intergenerational redistribution and risk sharing. While it is well known that a utilitarian planner strives for consumption smoothing, it is shown that healthy ageing calls for work smoothing in the sense that retirement ages increase with longevity. Hence, cohorts with higher longevity should contribute to their larger consumption needs via later retirement, although it is shown that the planner still front-loads some financing (pre-saving). Stochastic longevity raises the issue of intergenerational risk sharing, which implies that cohorts turning out to have a high longevity are compensated at the expense of cohorts turning out to have a relatively short longevity.

Dynamic Macro-Prudential Regulation

I propose a model in which government guarantees induce excessive aggregate lending by the financial sector. In response, the regulator sets macro-prudential capital requirements to trade-off growth (expected output) with financial stability (lower probability and social cost of a banking sector collapse). This trade-off depends on the state of the economy and optimal capital requirements are therefore not constant. I first establish in a risk-neutral benchmark that the optimal macro-prudential capital requirements are higher in good times if the long-run productivity-elasticity of aggregate banking capital is larger than that of the optimal stock of physical capital. Then, I show that this condition is always satisfied in a simple OLG model with a neoclassical production function. The transition dynamics of optimal requirement, however, depend on the difference in the short-run productivity-elasticities, which can go either way. Risk aversion affects the level of optimal requirements, but only extreme cyclical variations of effective risk aversion would substantially modify their cyclical properties. Finally, I compare the optimal policy to the (best possible) constant capital requirement and show that the latter not only generates excess volatility but also episodes of extreme over-lending. In such cases, there is no longer a trade-off: an increase in capital requirement would both be good for growth and improve financial stability.

Love thy children or money

This paper presents a simple OLG model which is consistent with observed consumer behavior, capital accumulation and wealth distribution, and yields some new conclusions about fiscal policy. By considering a society in which individuals are distinguished according to two characteristics, altruism and wealth preference, we show that those who in the long run hold the bulk of private capital are not so much motivated by dynastic altruism as by preference for wealth. In this setting, estate taxation is a questionable instrument of redistribution: it penalizes the wealthy, but favors the top wealthy. On the other hand, even though Ricardian equivalence holds, both public debt and PAYG pensions lead to a transfer of resources from the top wealthy to the other individuals.

When the State Mirrors the Family: The Design of Pension Systems

This paper studies the transmission mechanism from family culture to economic institutions, by analyzing the impact of the within family organization on the original design of the public pension systems. We build a simple OLG model with families featuring either weak or strong internal ties. When pensions systems are initially introduced, in society with strong ties they replicate the tight link between generations by providing earnings related benefits; whereas in societies with weak family ties they only act as a safety net. To test this transition mechanism, we consider Todd (1982) historical classification of family types across countries. We find that in societies dominated by absolute nuclear families (i.e., weak family ties), pension systems act as a flat safety net entailing a large within-cohort redistribution, and viceversa in societies characterized by stronger family ties where pension systems are more generous. This link between the type of families and the design of pension systems is robust to testing for alternative explanations, such as legal origin, religion, urbanization and democratization of the country at the time of their introduction. Interestingly, historical family types matter for explaining the design of the pension systems, which represents a persistent feature, but not their size, which have largely changed over time.

Mortality, Fertility, Education and Capital Accumulation in a Simple OLG Economy

We develop a simple overlapping generations model to analytically show that population aging leads to increased educational efforts through a general equilibrium effect. The key mechanism at work in the model is that scarcity of raw labor increases the rate of return to human capital relative to physical capital. While a reduction in the birth rate is shown to unambiguously increase educational efforts, increases in the survival rate have ambiguous effects. Falling birth rates unambiguously increase capital per worker while the effects of rising survival rates are ambiguous. When evaluating our model using a calibrated version we and that education always increases if life expectancy rises but the effect on the capital stock is still ambiguous and depends on the parameters of the model. We conclude that our model is a useful laboratory to highlight the various potentially offsetting effects at work in models with endogenous education and overlapping generations which is key for understanding the magnitudes of results of applied quantitative general equilibrium analyses employing such a framework.

Mortality, fertility, education and capital accumulation in a simple OLG economy

We develop a simple OLG model to analytically show that aging leads to increased educational efforts through a general equilibrium effect. The mechanism is that scarcity of raw labor increases the return of human relative to physical capital. While a reduction in the birth rate is shown to unambiguously increase educational efforts, increases in the survival rate have ambiguous effects. Falling birth rates also increase capital per worker, but the effects of rising survival rates are again ambiguous. We conclude that our model is a useful laboratory to highlight potentially offsetting effects in models with endogenous education and overlapping generations.

Investing for the old age: pensions, children and savings

In the last century, most countries have experienced both an increase in pension spending and a decline in fertility. We argue that the interplay of pension generosity and development of capital markets is crucial to understand fertility decisions. Since children have traditionally represented for parents a form of retirement saving, particularly in economies with limited or nonexistent capital markets, an exogenous increase of pension spending provides a saving technology alternative to children, thus relaxing financial (saving) constraints and reducing fertility. We build a simple two-period OLG model to show that an increase in pensions is associated with a larger decrease in fertility in countries in which individuals have less access to financial markets. Cross-country regression analysis supports our result: an interaction between various measures of pension generosity and a proxy for the development of financial markets consistently enters the regressions positively and significantly, suggesting that in economies with limited financial markets, children represent a (if not the only) way for parents to save for old age, and that increases in pensions amount effectively to relaxing these constraints.

Investing for the Old Age: Pensions, Children and Savings

In the last century most countries have experienced both an increase in pension spending and a decline in fertility, We argue that the interplay of pension generosity and development of capital markets is crucial to understand fertility decisions. Since children have traditionally represented for parents a form of retirement saving, particularly in economies with limited or non-existent capital markets, an exogenous increase of pension spending provides a saving technology alternative to children, thus relaxing financial (saving) constraints and reducing fertility. We build a simple two-period OLG model to show that an increase in pensions is associated with a larger decrease in fertility in countries in which individuals have less access to financial markets. Cross-country regression analysis support our result: an interaction between various measures of pension generosity and a proxy for the development of financial markets consistently enters the regressions positively and significantly, suggesting that in economies with limited financial markets, children represent a (if not the only) way for parents to save for old age, and that increases in pensions amount effectively to relaxing these constraints.

The Timing of Redistribution

We investigate whether late redistribution programs that can be targeted towards low income families, but may distort savings decisions, can “dominate” early redistribution programs that cannot be targeted due to information constraints. We use simple two-period OLG models with heterogeneous agents under six policy regimes: A model calibrated to the U.S. economy (benchmark), two early redistribution (lump sum) regimes, two (targeted) late redistribution regimes, and finally a model without taxes and redistribution. Redistribution programs are financed by a labor tax on the young and a capital tax on the old generation. We argue that late redistribution, if the programs are small in size, can dominate early redistribution in terms of welfare but not in terms of real output. Better targeting of low income households cannot completely offset savings distortions. In addition, we find that the optimal transfer and tax policy implies a capital tax of 100 percent and transfers exclusively to the young generation.