Asymmetric Shocks I

In an early paper (1998) Bryant et al took it upon themselves to examine - workshops held in Washington, Paris and Tokyo during July 1998 - "the areas in which we need to improve existing global analytical frameworks to deal with the range of important policy issues that will emerge as a part of the demographic shifts. The paper attempts to summarize what is now known, identifies areas where important unresolved debates still exist, and explores theoretical and empirical issues on which more research needs to be undertaken".

Their original goal was to take stock of what the economics profession knows about modeling the macroeconomic consequences of population aging. We focus particular attention on the likely consequences for changes in saving-investment-current-account balances and in asset prices -- for individual nations, and for the world economy as a whole.

The objectives of this project, with its emphasis on the cross-border consequences of demographic change, cannot be achieved without use of one or another multi-country, generalequilibrium macroeconomic model.


The most notable inadequacy in existing multi-country macro economic models is their failure explicitly to incorporate the effects of demographic changes. As preconditions for achieving the major objectives of the project, therefore, researchers working with the multicountry models must improve their equation specifications in at least three respects. An improved analysis is required of the effects of demographic changes on:

(1) consumption (including possibly patterns of consumption across different goods and services), saving, and wealth accumulation, with appropriate allowance for the openness of national economies;

(2) the production/supply sides of national economies, again with appropriate allowance for openness; and

(3) expenditures, transfers, and revenues in government budgets.

Most industrial countries have experienced two important behavioral trends. Labor force participation rates for male workers, especially in the last years of normal working life, have been declining. And labor force participation rates for female workers have been secularly rising. The first of these behavioral trends exacerbates the adverse effects of population aging on the effective labor force. The second has worked in an offsetting direction.


The key insight behind their work is, of course, that population aging will occur at differing paces and with differing degrees of intensity in the industrialized countries of the world.

So it is the relatively different pace of ageing which needs to be part of our focus. One thing is becoming clearer. Actually, if you look at it from this point of view, the whole demographic transition is an *ageing* one, after the initial kick-start. What do I mean? Well, initially you get a substantial rise in the birth rate and fall in infant mortality, which presumeably shoots the median age right down to all-time historic lows, and from there on, as they say, it's uphill all the way. Japan is currently just over 42 years old, and rising, and we don't know where the limit is.


During the July 1998 workshop discussions for this project, a large part of the dialogue was devoted to analytical methods for studying the consequences of demographic changes for consumption, saving, and wealth accumulation. Given the wide variety of analytical views held in the profession, this area is one of a few central topics on which substantial further research is warranted.

Some researchers interpret the empirical evidence as broadly supporting the lifecycle view, including the hypothesis that consumers are patient enough to begin saving for their retirement early in their working lifetimes. Examples of researchers sympathetic to the life-cycleview include Attanasio-Browning (1995) and Meredith (1995). Other researchers, however, read the empirical evidence as providing only weak support for the life-cycle view of saving and instead supporting the hypothesis that consumers save and accumulate wealth primarily to insulate consumption against uncertainty about fluctuations in income. In this latter view, the saving for retirement motive is much less important than the precautionary saving for uncertainty motive. (Precautionary saving for uncertainty leads to the accumulation of "buffer-stock" assets.)

Several participants in the July workshops emphasized the point that the life-cycle hypothesis, as studied in the context of microeconomic panel data, appears unable to account for the most prominent observed changes in several countries' saving behavior. For example, the lifecycle hypothesis does not do a good job of explaining the pronounced decline in the saving ratio in the United States in the last several decades. Nor can it explain the pronounced increases in saving ratios in several Asian countries (such as China, Indonesia, South Korea, Singapore, and Thailand.

A further difference of view in the saving-consumption literature concerns agents that in practice may not be able to borrow and lend freely as the simplified intertemporal smoothing models presume they can. The theoretical treatment and empirical importance of such liquidity constrained households is controversial.

In effect, the original LCH models contained no children and no elderly, with the result that a faster (steady-state) rate of growth of population caused the saving rate unambiguously to rise in response to higher requirements for investment and a higher capital stock. Tobin (1967) developed a simulation model differentiating workers from retirees (but still without children). Tobin's model also predicted that faster population growth would raise the private saving rate, because the faster growth caused the population distribution to become younger (more working, saving households relative to retirees who were older and dissaving).Even as theoretical growth models matured, most empirical macro models still abstracted from shifts in the demographic composition of the population. This omission persisted despite the major emphasis in consumption theory of life-cycle considerations in the microeconomic behavior of households.

When specifying the consumption-saving-wealth relationships in macroeconomic models,
issues of aggregation are very important. In particular, the aggregation issues are central for getting an adequate macro specification of the demographic influences. Macro models built up from a micro theory positing a single representative agent are not easily adapted so as to incorporate demographic changes. By definition, changes in the demographic composition of the population require analysis to acknowledge the heterogeneity of agents -- at the very least heterogeneity in age.

As they then go on to explain, there is another class of models, the overlapping generations one, which attempts to grapple directly with one or more dimensions of heterogeneity across agents.

So the OG models could be more promising, but, there are no free lunches. They are much more difficult to construct and work with:

An explicit multi-cohort approach, at least seen from some perspectives, appears more rigorous theoretically. But such an approach may also be more difficult and demanding, and will probably take much longer to advance to the stage where the models can deliver interesting empirical conclusions. The requirements of a multi-cohort specification are of course especially demanding in a model with numerous separate national economies and national currencies. Another possible disadvantage of the multi-cohort specification is that it might, if calibrated to partial-equilibrium relationships derived from micro-level evidence, deliver misleading inferences about aggregative macroeconomic relationships.


They inform us that they build on earlier theoretical work by Blanchard, P. Weil, Faruqee, Laxton, and Symansky, who use a revised life cycle approach to consumption and saving behaviour. (Actually, the MIT opencourseware, just coincidentally, has some notes on the OLG model, they are a bit technical, but here they are).


The Blanchard model could be called 'forever young'.

Bryant and Mckibbin allow changes in birth and mortality rates to be combined with an approximation of age-earning profiles in orderto allow demographic shifts to influence human wealth, consumption, and asset accumulation. They do this using two simplified empirical models: (i) a two region abridgement of the IMF’s MULTIMOD model and (ii) a two-region abridgement of the McKibbin MSG3 multi-country model. As they indicate "the stylized shock on which we initially focus is an unanticipated and transitory demographic bulge, analogous to the "baby boom" experienced by some industrial nations several decades ago."

So this is a very partial and specific shock. What this model effectively looks at it an 'ageing' scenario, where one very large cohort distorts the age pyramid as it moves upwards.They use a two economy (home and away) model to test for this shock both on an equally distributed and on a lop-sided (restricted to one country) basis.

They report that their research "strongly confirms the hypothesis that differences across countries in the timing and intensity of demographic shifts can have significant effects on exchange rates and cross-border trade and capital flows".

Parts of the paper reads - even word for word - as very similar to the 1998 one.

This part, which I didn't go into in any detail before is important:

The tradeoff facing researchers about the two routes is primarily a matter of time horizon. Multi-cohort OLG approaches that explicitly keep track of different cohorts, their saving decisions, and their wealth stocks can be more rigorous theoretically. Other things being equal, a multi-cohort OLG approach thus may appear more attractive. But other things are not equal. Multi-cohort OLG models are more difficult and demanding than models that use analytical shortcuts to get demographic effects into the consumption-saving specifications in macroeconomic models. The OLG
models, moreover, are likely to take much longer to advance to the stage where the models can deliver interesting empirical conclusions. The requirements of a multi-cohort specification are of course especially demanding in a model with numerous separate national economies and national currencies.

Another disadvantage of the multi-cohort OLG specification is that it might, if calibrated only to partial-equilibrium relationships derived from micro-level evidence, deliver misleading inferences about aggregative macroeconomic relationships. As Hamid Faruqee emphasized to us in a comment made after the international workshops that launched this project, it is both the virtue and the vice of a micro-level specification for individual agents that variables such as goods prices and interest rates are taken as exogenously given. Goods prices and interest rates self-evidently cannot be modeled as exogenous at an aggregative, economy-wide level. It is thus unclear whether a disaggregated OLG model, based on partial-equilibrium relationships estimated from micro-level data, will yield correct inferences and predictions for general-equilibrium, macroeconomic behavior (in the sense of being able to replicate the moments of actual macroeconomic data).

Blanchard showed that a simplifying assumption can expedite aggregation and modeling and thereby allow a researcher to avoid the adoption of a more complex and analytically difficult multicohort OLG approach. Blanchard’s key assumption was that each individual, throughout life and regardless of age, faces a constant probability of death, p. The expected life of an individual is thus 1/p . With this assumption, researchers can choose a value for p anywhere between zero and a large number. If p is put at the limiting case of zero,individuals live forever and the model yields the infinite-horizon results familiar from still simpler models; values of p in the range .03 to .01 yield model "life expectancies" in the range of 33 to 100 years.

The constant-probability-of-death assumption can be combined with an assumption, based on Yaari (1965), that the economy contains life insurance companies permitting agents to costlessly make annuities contracts contingent on their deaths.18 The two assumptions together permit the derivation of an aggregate consumption function without keeping explicit track of the consumption and wealth of multiple cohorts. Aggregate consumption turns out to be a relatively simple linear function of human and non-human (financial) wealth, with the marginal propensity to consume dependent on the age-invariant probability of death and individuals’ rate of time preference.

The authors inform us that in order to facilitate a clearer comparison of models and alternative treatments of economic behavior they constructed stylized and simplified versions of two existing macroeconomic models. The first a stylized, two-region
abridgement of the IMF staff’s MULTIMOD model as modified by Bryant and Long Zhang, and secondly a stylized, two-country abridgement of the McKibbin and Wilcoxen G-Cubed models.

The cyclical movements in per capita human wealth and consumption during the years 10 to 30 and the associated cyclical behavior of other domestic macroeconomic variables are partly due to the fact that the new members of the population resulting from the (adult) baby bulge are at first relatively low savers. Speaking loosely, these younger adults are ascending the left side of the hump of their age-earning profiles (Figures 1 and 2). As the bulge cohorts reach their years of peak earnings and high savings, another inflection point is reached. Per capita human wealth and consumption in the fourth decade of the shock begin a long decline relative to baseline. Eventually, as the baby boomers become elderly, their labor income and human wealth decline and they begin to consume out of their financial wealth. Per capita consumption in the long run returns to the baseline level of the initial steady state.