Assignment 2 - OLG Model with No Population Growth and PAYG

Pension Scheme

Tomas Bjarnason

April 4, 2017
Model Specification
Individuals
The model in question is an OLG model with no population growth (n = 0) and a Pay-as-you-go pension
scheme facilitated by a government sector. As in any OLG model, individuals live in two distinct periods,
in which they can be thought of as Young (or net contributors to the pension scheme) in the first period,
and Old (or net receivers of the pension scheme) in the second period. We assume that individuals are
homogeneous within cohorts, and that they only care about their own well-being when maximizing utility
function or voting on political issues
The lifetime utility is characterized by the following function:

Ut = c1,t + ln(c2,t+1 ) (1)

which the individual will try to maximize with respect to c1,t and c2,t+1 such that the individuals period
budget constraints hold.

The period budget constraints are as follows:

c1,t = wt (1 ) st
c2,t+1 = st Rt+1 + wt
where wt is the wage (and the labour income), st is individual savings, Rt+1 is the gross interest rate and
is the tax rate on labour income of the young, and which is awarded to the old in the same period as benefits.

Firms
To characterize aggregate firm behaviour, we must find the aggregate production function. Since all firms
have the same production function, the aggregate production function must be the sum of the production
functions for each firm. Assuming there are n firms in the economy, the aggregate production function can
be written as:
n
X n
X n
X
Yti = A (Kti ) Kt1 (Nti )1 (2)
i=1 i=0 i=0

By definition, the sum of individual firms capital stock must be Kt and the sum of individual firms workers
must be Nt . Therefore, this equation can be written as:

Y = AKt Kt1 Nt1 = AKt Nt1 (3)

Since there is no population growth, Nt can be normalized to one. In addition to the production function,
we know that firms in the economy can trade goods with the rest of the world, however production factors
are assumed to be non-tradeable.

a) Marginal products of labour and capital.

We want to show that rt is unaffected by the capital stock, and that wt = (1 )AKt . To show this, we
take the first order conditions of the aggregate production function:
Yt Yt
= rt ANt1 = A = r = wt (1 )AKt = wt (4)
Kt Nt
and see that Kt does not enter the solution for rt , and wt is the same function we wanted to show.

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b) Savings and Capital Accumulation on BGP
To find savings, we insert the period budget constraints into the individuals lifetime utility function and take
the first order condition with respect to st (dropping the time subscript on R since it is independent of time
dependent terms, and so the gross interest rate is unchanged from period to period):

Ut R
=0 =1
st st R + wt
R = st R + wt
( st )R = wt
wt
st =
R
R wt
st = (Optimal Savings Rate)
R
Once we have found the optimal savings rate, we can calculate the capital accumulation function. Since
production function can not be traded between countries, and capital is a production factor, we can conclude
that capital accumulation is only dependent on, and equal to, savings in the economy. Furthermore, since
population growth is zero, the capital intensity equals the optimal savings rate:

R wt
kt+1 = st =
R
R (1 )Akt
kt+1 = (Capital Accumulation)
R

Now there are some changes to the economy:

The government decreases PAYG system contributions: In period t0 , the old receive (1) wt0 instead
of wt0
However, the young only make contributions for (1 ) wt0
The difference is financed by issuing debt, a fraction of which is bought by foreigners.

Total issued debt: (1 )(1 ) wt0

Foreign debt: (1 )(1 ) wt0
Domestic debt: (1 )(1 )(1 ) wt0

From period t0 and onwards, the government charges a fraction of the previous contribution to pay for
social security: (1 ) wt

The government keeps its total debt stable at (1 )(1 ) wt0 , and finances interest payments by
lump sum taxes on the young

This set-up leads to new budget constraints for three groups of agents in the economy: The initial young in
t0 , the initial old in t0 , and future generations. Their respective budget constraints will now be:

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 For the initial young:

c1t = wt0 st0 (1 ) wt0 c2t+1 = st R + (1 ) wt1

For the initial old:

c2t+1 = st R + (1 ) wt0

And for future generations:

c1t = wt st (1 ) wt (1 )(1 ) wt0 A c2t+1 = st R + (1 ) wt1

We want to examine three effects:

The optimal savings effect

The capital accumulation effect, and
The current account effect.

Savings
Even though the budget constraints for initial young and future generations when young are different, this
will not matter when differentiating the utility function because of its functional form (if we had logarithmic
utility for example, it would matter). Therefore, even though we would perhaps expect a lower savings rate
from future young if they have to pay interest on government debt (i.e. if > 0) this will not be the case,
and the savings rate from period t0 and onwards can be found by differentiating either the utility function
of initial young or future generations:

Ut R
=0 1=
st st R + (1 ) wt
st R = R (1 ) wt
R (1 ) wt
st = (New Optimal Savings Rate)
R

Capital accumulation
When the government issues debt to foreign and domestic buyers, only the debt that is bought domestically
can crowd out investment.
Therefore, capital accumulation in this new economy will be given by:

kt+1 = st (1 )(1 )(1 ) wt0

R (1 ) wt
kt+1 = (1 )(1 )(1 ) wt0
R
R (1 ) (1 )Akt
kt+1 = (1 )(1 )(1 ) (1 )Akt0 (New Capital Accumulation)
R

Current Account
We denote the economys current account equation as:

CAt = (bt+1 bt ) + s1t s1t1

where the debt is normalized in terms of tomorrows young, and the government budget constraint is denoted
as bt+1 = Rbt + gt wt + wt .

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When the budget is balanced the debt level is 0, and therefore government spending must necessarily equal
government income from taxes. Mathematically, we see that bt+1 = bt = 0 gt = wt + wt = 0

When the government lowers social security in t0 we see that the governments budget constraint becomes:

b0 = R b1 + g0 (1 ) wt0 + (1 )(1 ) wt0

b0 = (1 )(1 ) wt0
And in period t1 and onwards, the government keeps the debt level constant by financing interest rate
payments with taxes on future generations:

b1 = R b0 (R 1) b0 = b0
bt = (1 )(1 ) wt0 for t [t0 , ] (Current Account Deficit)
Using these general equations, we can examine the difference in what happens when the government lowers
social security for = 0 and = 1 respectively.

c) The Case of = 0
If = 0, the initial young pay no taxes in period t0 . That is, all of the social security payment to the initial
old is paid for by issuing debt.

Regarding savings, we see that for = 0, the new optimal savings rate is st = R R = . Comparing this to
R wt
the old optimal savings rate, st = R , we see that since R > R wt , the new savings rate is larger
than the old one. Intuition: Since the initial young pay no taxes, their disposable income will increase to
equal l.abour income in period t0 . As each household allocates income between savings and consumption
according to the patience parameter , they will allocate part of the increase in disposable income to
savings and part (1 ) to consumption.

From period t1 , future generations pay (1 ) wt in taxes in every period, so the optimal savings rate
becomes st = R(1)
R
wt
, which is still larger than the old optimal savings rate (as we will see in section
d), but smaller than .

As for capital accumulation, the New Capital Accumulation equation becomes:

kt0 +1 = (1 )(1 ) (1 )Akt0

Because the tax that the young pay crowds out their savings, savings must go up when the tax falls. When
social security is lowered, there are more savings available for investment, which affects capital accumulation
in a positive way.

In fact, there are two opposite effects on the capital accumulation equation in this setting:
(1)Akt
the savings rate is larger by R , which increases the capital accumulation, and
investment is crowded out by domestic debt, (1 )(1 ) (1 )Akt0 , which decreases capital
accumulation.
The difference between the old and the new capital accumulation is therefore positive as long as the increase
from savings is larger than the decrease from crowding out:

(1 )Akt0
> (1 )(1 ) (1 )Akt0
R

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which is positive as long as
1
> (1 )(1 )
R
This means that if all the debt is bought by foreigners, there will be no crowding out in the economy, but if
all the debt is domestically bought, the effect on capital accumulation will depend on whether the remaining
benefits after the permanent reduction is bigger than the inverse gross interest rate. If the inverse gross
interest rate is bigger, then capital accumulation is larger.

For the Current account, we see that the government runs a deficit dependent on the size of the parameter
. We know from the assignment text that the government keeps its debt level at:

b0 = (1 )(1 ) wt0
As for political support, let us consider this:

The initial old receive lower income in t0 , since there is a permanent reduction of their benefits and they
have already made their savings in the previous period. In all likelihood, given the assumption that each
generation votes in their own interest, the inital old would vote no to a reduction in benefits.

In the case of initial young, the question comes down to whether they can make a better return on population
growth (n) or savings (r ). Since n = 0, then as long as r = A > (a reasonable assumption on a balanced
growth path) we have dynamic efficiency, and initial young will vote yes to lowering benefits so they can
reap the rewards of higher savings.

Future generations do not vote, but they will be worse of for having to service the interest payments of
government debt taken in favor of the initial young.

d) The Case of = 1
If = 1, the initial young pay full taxes in period t0 . That is, none of the social security payment to the
initial old is paid for by issuing debt.
R(1) wt
For savings, we see that for = 1, the new optimal savings rate is st = R .

Comparing this to the old optimal savings rate, st = RR

wt
, we see that since (1 ) wt < wt , the new
savings rate is larger than the old one. Because the lower social security tax benefit payment means lower
consumption when old and a larger income when young, the young will increase savings in order to smooth
consumption.

As for capital accumulation,

R (1 ) (1 )Akt
kt+1 = (1 )(1 )(1 ) (1 )Akt0
R
becomes

R (1 ) (1 )Akt
kt+1 =
R
when = 1.

In this setting, there is no crowding out of investment since benefit payments are financed by taxes and
not debt. Furthermore, this capital accumulation equation is larger than the Old Capital Accumulation
Equation, since (1 ) (1 )Akt < (1 )Akt . The additional capital accumulation occurs because of
the previously mentioned increase in savings.

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The current account deficit in this scenario is equal to zero, since none of the benefits payment is financed
by issuing debt and we assume that the government is running a balanced budget before the change.

Political support from the initial old will be the same as in c, since their budget constraint is the same in
both cases. Therefore, the initial old will vote no to a reduction of social security benefits.

If the change goes through, the initial young will pay lower taxes when young, but also receive less benefits,
and will need to increase their savings to smooth consumption. However, since the rate of return on savings
is higher than the return on population (the economy is dynamically efficient), overall utility of the initial
young rises when income is allocated from taxes to savings, and therefore the young will vote yes to a
reduction of social security benefits.

Since there is no debt to service in subsequent periods, discussion future generations is irrelevant.

e) General equilibrium results of = 1

In general equilibrium, it is not assumed (as in partial equilibrium) that wages and interest rates are un-
affected. However, since the interest rate is independent of any time-dependent variable it too is a time-
independent variable, independent specifically of kt . Wages are not, so we will now include in the analysis
the effect of a change in capital on wages.

We start by finding the steady state value of capital in the Old Capital Accumulation equation:

R (1 )Akold
kt+1 = kt = k
kold =
R
(1 )A R
(1 + )kold =
R R
R
kold =
R + (1 )A
(1 + A)
kold =
(1 + A) + (1 )A
(1 + A)
kold =
1 + (1 + (1 ))A

and the old steady state value of wages:

R
wt+1 = wt = w = (1 )Ak w = (1 )A( )
R + (1 )A
(1 )AR
w =
R + (1 )A
(1 )A(1 + A)
w =
1 + (1 + (1 ))A

and contrast them with the steady state value of capital in the New Capital Accumulation equation:

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R (1 ) (1 )Aknew
kt+1 = kt = k
knew =
R
(1 ) (1 )A R
(1 + )knew =
R R
R
knew =
R + (1 ) (1 )A
(1 + A)
knew =
(1 + A) + (1 ) (1 )A
(1 + A)
knew =
1 + (1 + (1 ) (1 ))A

and the new steady state value of wages:

R
wt+1 = wt = w = (1 )Ak w = (1 )A( )
R + (1 ) (1 )A
(1 )AR
w =
R + (1 ) (1 )A
(1 )A(1 + A)
w =
1 + (1 + (1 ) (1 ))A

The comparison yields the conclusion that a permanent reduction in tax benefits leads to higher wages and
more capital in steady state (This should be plain to see, but the numerator is the same in both cases while
the denominator is smaller, which yields the conclusion).

In addition to the increase in savings found in d), we now see an additional increase in savings because of
higher wages.

The current account deficit is still zero as in d), since there is no debt issued to pay for benefits to the old.

Political support among the old will not change, as the initial old are still subject to a decrease in welfare.
The political support among the young will also stay the same, as they will feel a significant increase in
welfare. The initial old will therefore still vote no, and the young will vote yes. It should be noted that
getting both groups to support this idea would be impossible, since there is no Pareto-improving way to
reduce the PAYG pension scheme.