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B. J. Heijdra & F. van der Ploeg

Chapter 17: Intergenerational Economics,

II

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 2

• Study second “work-horse” model of overlapping generations based on discrete

time. Motivation for doing this:

Auerbach & Kotlikoff)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 3

– funded vs. unfunded pensions

– pension reform

– growth and human capital

– public investment

– intergenerational accounting

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 4

Households

• live two periods: “youth” (superscript Y ) and “old age” (superscript O)

• consume in both periods

• work only during youth

• unlinked with past or future generations (no bequests)

• save during youth to finance old-age consumption (life-cycle saving)

• utility function of young agent at time t:

µ ¶

1

ΛYt ≡ U (CtY ) + O

U (Ct+1 )

1+ρ

– U (·) is felicity function (Inada-style conditions)

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 5

• budget identities:

CtY + St = Wt

O

Ct+1 = (1 + rt+1 )St

– St is saving

– Wt is wage income (exogenous labour supply)

– rt+1 is real interest rate

• consolidated (lifetime) budget constraint:

O

Ct+1

Wt = CtY +

1 + rt+1

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 6

U 0 (Ct+1

O

) 1+ρ

0 Y

=

U (Ct ) 1 + rt+1

• savings function:

St = S(Wt , rt+1 )

– 0 < SW < 1: both goods are normal

– Sr ambiguous (offsetting income and substitution effects)

– if intertemporal substitution elasticity is high (σ > 1) then Sr > 0 (and vice

versa)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 7

Firms

• perfect competition, CRTS technology Yt = F (Kt , Lt ), Inada conditions

• hire Lt from young (at wage Wt ) and Kt from old (at rental rate rt + δ ):

Wt = FL (Kt , Lt )

rt + δ = FK (Kt , Lt )

rt+1 + δ = FK (Kt+1 , Lt+1 )

• intensive-form expressions:

yt = f (kt )

Wt = f (kt ) − kt f 0 (kt )

rt+1 + δ = f 0 (kt+1 )

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 8

• resource constraint:

Yt + (1 − δ)Kt = Kt+1 + Ct , (A)

Lt CtY = Wt Lt − St Lt

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 9

= Yt + (1 − δ)Kt − St Lt (B)

St Lt = Kt+1

saving by the young determines the future capital stock

• Population growth:

Lt = L0 (1 + n)t , n > −1

• Intensive-form expression:

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 10

• Model can be expressed in single nonlinear difference equation:

· ¸

(1 + n)kt+1 = S f (kt ) − kt f 0 (kt ), f 0 (kt+1 ) − δ

| {z } | {z }

Wt rt+1

dkt+1 −SW kt f 00 (kt )

=

dkt 1 + n − Sr f 00 (kt+1 )

¯ ¯

¯ dk ¯

– stability condition is ¯ dkt+1 ¯ < 1

t

– denominator is ambiguous (because Sr is)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 11

µ ¶

²L

kt+1 = g(kt ) ≡ kt1−²L

(1 + n)(2 + ρ)

– Figure 17.1 shows the phase diagram

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 12

kt+1=kt

kt+1

B

kt+1=g(kt)

A !

! E0

! !

45N

k0 k* kt

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 13

Efficiency

• Ignoring transitional dynamics, what would an optimal steady-state look like?

• Optimal steady-state is such that the lifetime utility of a “representative” young agent

is maximized subject to the resource constraint:

µ ¶

Y Y 1

max Λ ≡ U (C ) + U (C O )

{C Y ,C O ,k} 1+ρ

O

C

subject to: f (k) − (n + δ)k = C Y +

1+n

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 14

– FONC #1, biological-interest-rate consumption golden-rule:

U 0 (C O ) 1+ρ

0 Y

=

U (C ) 1+n

– FONC #2, production golden-rule:

f 0 (k) = n + δ

there is overaccumulation (dynamic inefficiency). This is quite possible in the

unit-elastic model.

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 15

• Old-age pensions

– fully-funded versus pay-as-you-go (PAYG) pensions

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 16

Old-age pensions

• to study a pension system we must add government taxes and transfers to the model

• budget identities:

CtY + St = Wt − Tt

O

Ct+1 = (1 + rt+1 )St + Zt+1

– Zt is transfer provided to the old

• consolidated lifetime budget constraint:

O

Zt+1 Ct+1

W t − Tt + = CtY +

1 + rt+1 1 + rt+1

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 17

– Fully-funded system:

Zt+1 = (1 + rt+1 )Tt

Contribution Tt earns market interest rate (rt+1 )

– PAYG system:

Lt−1 Zt = Lt Tt ⇔ Zt = (1 + n)Tt

Contribution Tt earns the right to receive (1 + n)Tt+1 when old, where n is the

biological interest rate

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 18

Fully-funded pensions

• striking neutrality property

• recall that lifetime budget constraint is:

O

Zt+1 Ct+1

W t − Tt + = CtY +

1 + rt+1 1 + rt+1

• recall that under fully-funded system we have:

O

Ct+1

Wt = CtY +

1 + rt+1

• economies with or without fully-funded system are identical!

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 19

• Intuition: household only worries about its total saving St + Tt = S (Wt , rt+1 ).

Part of this is carried out by the government but it carries the same rate of return.

• Proviso: system should not be “too severe” (Tt < S (Wt , rt+1 )). Otherwise

households are forced to save too much by the pension system.

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 20

PAYG pensions

• features transfer from young to old in each period

• We look at defined-contribution system: Tt = T for all t so that Zt+1 = (1 + n)T

• household lifetime budget constraint becomes:

µ ¶ O

rt+1 − n Ct+1

Ŵt ≡ Wt − T = CtY +

1 + rt+1 1 + rt+1

• ceteris paribus factor prices, the PAYG system expands (contracts) the household’s

resources if the market interest rate, rt+1 , falls short of (exceeds) the biological

interest rate (n)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 21

µ ¶ · µ ¶µ ¶¸

1 1+ρ rt+1 − n

S(Wt , rt+1 , T ) ≡ Wt − 1 − T

2+ρ 2+ρ 1 + rt+1

with 0 < SW < 1, Sr > 0, −1 < ST < 0 (if rt+1 > n), and ST < −1 (if

rt+1 < n).

• capital accumulation:

Wt ≡ W (kt ) = ²L kt1−²L

−²L

rt+1 ≡ r(kt+1 ) = (1 − ²L )kt+1 −δ

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 22

– two equilibria: unstable on (at D) and stable one (at E0 )

– introduction of PAYG system is windfall gain to the then old but leads to crowding

out of capital (see path A to C to E0 ). In the long run, wages fall and the interest

rate rises.

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 23

kt+1=kt

kt+1

B kt+1=g(kt,0)

!

A

! kt+1=g(kt,T)

!

E0

C!

D

!

! !

kMIN k0 k*(T) k* kt

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 24

• Ignoring transitional dynamics, what is the effect on welfare if T is changed

marginally?

– Indirect utility function

½ O

¾

Y Y Y O Y C

Λ̄ (W, r, T ) ≡ max Λ (C , C ) subject to Ŵ = C + ,

Y

{C ,C }O 1+r

with: µ ¶

r−n

Ŵ = W − T

1+r

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 25

∂ Λ̄Y ∂ΛY

= Y

>0

∂W ∂C

µ ¶

∂ Λ̄Y S ∂ΛY

= Y

>0

∂r 1 + r ∂C

µ ¶

∂ Λ̄Y r − n ∂ΛY

= − Y

R0

∂T 1 + r ∂C

– wage effect: W ↓ which is bad for welfare

– interest rate effect: r ↑ which is good for welfare

– direct effect depending on sign of r −n

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 26

Wt = φ(rt )

dWt

≡ φ0 (rt ) = −kt

drt

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 27

dΛ̄Y ∂ Λ̄Y dW ∂ Λ̄Y dr ∂ Λ̄Y

= + +

dT ∂W · dT ∂r

µ dT ¶ ∂T µ ¶¸

Y

∂Λ dW S dr r−n

= Y

+ −

∂C dT 1 + r dT 1+r

µ ¶µ Y ¶· µ ¶¸

r−n ∂Λ dr

= − Y

1+k ∝ sgn(n − r)

1+r ∂C dT

• There is thus an intimate link between the welfare effect and dynamic (in)efficiency:

dΛ̄Y

– if r = n then dT

= 0 (no first-order welfare effects despite capital crowding out)

dΛ̄Y

– if economy is initially dynamically inefficient (r < n) then dT

> 0 (yield on

PAYG pension is higher than market interest rate and capital crowding out is a

good thing)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 28

• Ignoring transitional dynamics is not a good idea: there may be non-trivial welfare

costs due to transition from one to another equilibrium

the economy in the direction of the golden-rule equilibrium and improves welfare for

all generations during transition. Optimal to expand and not to abolish the system.

economy in the direction of the golden-rule equilibrium but during transition it

improves welfare for some generations (e.g. those born in the steady-state) and

deteriorates it for other generations (e.g. the currently old). How do we evaluate the

desirability?

– postulate social welfare function, weighing all generations

– adopt the Pareto criterion

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 29

system in a Pareto-improving manner: a cut in T makes the old worse off and there

is no way to compensate them without making some future generation worse off.

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 30

• Martin Feldstein: PAYG system not only affects the household’s savings decision but

also its retirement decision

income)

(the lazy get less than the diligent)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 31

– pension contribution acts like an employment subsidy if the so-called Aaron

condition holds

(Cobb-Douglas case has unique perfect foresight equilibrium)

non-distorting at the margin

possible

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 32

Households

• Retired in old-age but endogenous labour supply during youth (early retirement)

• utility function of agent i:

ΛY,i

t ≡ ΛY

(Ct

Y,i

, C O,i

t+1 , 1 − N i

t)

• budget identities:

O,i

Ct+1 i

= (1 + rt+1 )Sti + Zt+1

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 33

Tti = tL Wt Nti

• pension received during old age:

µ X j ¶ N i

Lt+1

i

Zt+1 = tL Wt+1 Nt+1 PLt t j

j=1 Nt

j=1

| {z } | {z }

(a) (b)

– Term (a): pension contributions of the future young generation (to be disbursed to

the then old)

fairness)

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 34

O,i

¡ ¢ Y,i C t+1

1 − tE

L,t W N

t t

i

= C t +

1 + rt+1

" µ ¶ Ã PLt+1 j ! µ ¶#

Wt+1 j=1 Nt+1 1

tE

L,t ≡ tL 1 − PLt j

Wt j=1 tN 1 + rt+1

– agent has perfect foresight regarding labour supply of the future young

L,t , different from the statutory tax rate, tL

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 35

O,i

, and Nti in order to maximize lifetime utility subject

to the lifetime budget constraint. First-order conditions:

Y

µ ¶µ Y

¶

∂Λ 1 ∂Λ

O,i

=

∂Ct+1 1 + rt+1 ∂CtY,i

· Y

¸ Y

µ Y

¶

∂Λ ∂Λ E ∂Λ

− i

= i

= (1 − tL,t )Wt

∂Nt ∂(1 − Nt ) ∂CtY,i

– MRS between future and present consumption is equated to the relative price of

future consumption

after-effective-tax wage rate

– it is not tL but tE

L,t which exerts a potentially distorting effect on labour supply

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 36

• Symmetric solution as all agents are identical: Nti = Nt . With constant population

growth Lt+1 = (1 + n)Lt and tE L,t simplifies to:

· µ ¶µ ¶µ ¶¸

E Wt+1 Nt+1 1+n

tL,t ≡ tL 1 −

Wt Nt 1 + rt+1

• tE

L,t is negative if the Aaron condition holds, i.e. if the combined effect of growth in

wage income and in the population exceeds the interest rate:

µ ¶

∆Wt+1 Nt+1

tE

L,t <0 ⇔ 1+ (1 + n) > 1 + rt+1

W t Nt

– growth in wage income widens the revenue obtained per young household

– population growth increases the number of young households and thus widens

the total revenue

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 37

– depends on Aaron condition (is tE

L,t negative of positive?)

The macroeconomy

• Relation between household saving and the capital-labour ratio:

St = (1 + n)Nt+1 kt+1

where kt ≡ Kt / (Lt Nt ).

• Labour supply and the savings function:

¡ E

¢

Nt = N Wt (1 − tL,t ), rt+1

O

¡ E

¢

C Wt (1 − tL,t ), rt+1 − (1 + n)tL Wt+1 Nt+1

S [·] ≡

1 + rt+1

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 38

£ E

¡ E

¢¤

S Wt (1 − tL,t ), rt+1 , tL Wt+1 N Wt+1 (1 − tL,t+1 ), rt+2

¡ E

¢

= (1 + n)N Wt+1 (1 − tL,t+1 ), rt+2 kt+1

via the factor prices alone!

– (worse) tE L,t+1 depends on N t+2 which itself depends on k t+2 , k t+3 , and t E

L,t+2

(infinite regress)

τ =0 so

there is a continuum of perfect foresight equilibria

– (but) if the utility function is Cobb-Douglas, then labour supply is constant and the

perfect foresight equilibrium is unique (case discussed below)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 39

• Despite non-uniqueness of transition path, the steady state equilibrium is unique, so

we can study its welfare properties

Λ̄Y (W, r, tL ) ≡ max ΛY (C Y , C O , 1 − N )

{C Y ,C O ,N }

· µ ¶¸

r−n Y CO

subject to: W N 1 − tL =C +

1+r 1+r

• The welfare effect of a marginal change in the statutory tax is:

µ ¶µ ¶· µ ¶¸

dΛY r−n ∂ΛY dr

= −N Y

W + (1 − tL )k

dtL 1+r ∂C dtL

– no first-order welfare effect if r = n (golden-rule equilibrium)

dr

– if r 6= n then welfare effect is ambiguous because dtL

is ambiguous

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 40

Cobb-Douglas preferences

• Assume that the utility function is now:

µ ¶

1

ΛYt ≡ log CtY + λC log[1 − Nt ] + log CtO

1+ρ

where λC ≥ 0 regulates the strength of the labour supply effect.

• Optimal household decision rules:

µ ¶

1+ρ

CtY = WtN

2 + ρ + λC (1 + ρ)

µ ¶

O 1 + rt+1

Ct+1 = WtN

2 + ρ + λC (1 + ρ)

2+ρ

Nt =

2 + ρ + λC (1 + ρ)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 41

with:

· µ µ ¶µ ¶¶¸

Wt+1 1+n

WtN ≡ Wt (1 − tE

L,t ) ≡ Wt 1 − tL 1 −

Wt 1 + rt+1

– labour supply is constant (IE and SE offset each other)

– consumption during youth depends on the future interest rate via the effective tax

rate

µ ¶µ ¶

W (kt )(1 − tL ) 1+ρ tL (1 + n) W (kt+1 )

(1 + n)kt+1 = −

2+ρ 2+ρ 1 + r(kt+1 )

– first-order difference equation in the capital-labour ratio so the transition path is

determinate

– an increase in tL leads to crowding out of the steady-state capital stock (just as when

lump-sum taxes are used)

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 42

• Unlike the lump-sum case, the increase in tL causes a distortion in the labour supply

decision (provided r 6= n)

– recall that the deadweight loss of the distorting tax hinges on the elasticity of the

compensated labour supply curve (which is positive) not of the uncompensated

labour supply curve (which is zero for CD preferences).

used during transition, a gradual move from PAYG to a funded system is possible

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 43

• Deadweight loss of a distorting tax: the loss in welfare due to the use of a distorting

rather than a non-distorting tax.

• In the context of our model, the DWL of the pension tax tL can be illustrated with

Figure 17.3

• Model solved in two steps to develop diagrammatic approach

• We define lifetime income as:

· µ ¶¸

r−n

X ≡ W N 1 − tL ≡ W N (1 − tE

L)

1+r

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 44

X

TE

EE

IC

E0

! ! E0

E2

!

E1

! ! E1

!B

A

!

!

-N 0 CO

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 45

µ ¶

Y 1

log C + log C O ,

1+ρ

subject to the constraint:

O

C

CY + =X

1+r

This yields:

µ ¶ µ ¶

Y 1+ρ O 1+r

C = X, C = X

2+ρ 2+ρ

The second expression is plotted in the right-hand panel of Figure 17.3.

• By substituting the solutions for C Y and C O into the utility function we find:

µ ¶

Y 2+ρ

Λ ≡ log X + λC log[1 − Nt ] + constant

1+ρ

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 46

X = W N (1 − tE L ). The resulting expressions are:

2+ρ

N =

2 + ρ + λC (1 + ρ)

(2 + ρ) W (1 − tE

L)

X =

2 + ρ + λC (1 + ρ)

The maximization problem is shown in the left-hand panel of Figure 17.3: IC is the

indifference curve and TE is the constraint. Both are downward sloping because

−N is measured on the horizontal axis!

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 47

L = 0 is given by point E0 in both panels. Now consider

what happens if tE

L is increased:

– 0B is the income one would have to give the household to restore it to its initial

indifference curve IC (hypothetical transfer Z0 )

LWN)

• If lump-sum tax were used then the slope of TE would not change and the DWL

would be zero (hypothetical transfer equal to tax revenue).

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 48

• The old-age dependency ratio is the number of retired people divided by the

working-age population

L 1

constant: Lt−1 = 1+n .

t

– in the OECD and the US the population is ageing: proportion of young falls whilst

proportion of old rises

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 49

1950 1990 2025

World

0-19 44.1 41.7 32.8

20-65 50.8 52.1 57.5

65+ 5.1 6.2 9.7

OECD

0-19 35.0 27.2 24.8

20-64 56.7 59.9 56.6

65+ 8.3 12.8 18.6

United States

0-19 33.9 28.9 26.8

20-65 57.9 58.9 56.0

65+ 8.1 12.2 17.2

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 50

– decrease in fertility

– decrease in mortality

• We can study the first effect with D-S model: focus on interaction with pension

system

Revised model

• Population:

Lt = (1 + nt ) Lt−1

with nt variable

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 51

• Saving-capital link:

(Zt+1 = (1 + nt+1 ) T ), and saving increases.

– LHS: a reduction in nt+1 allows for a higher capital-labour ratio for a given level of

saving

• A permanent decrease in the fertility rate increases the long-run capital stock. The

transition path is shown in Figure 17.4. Economy-wide asset ownership rises

because the proportion of old increases.

• Qualitatively the same conclusion as Auerbach & Kotlikoff reach on basis of detailed

CGE model!

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 52

kt+1=kt

kt+1

E1

! kt+1=g(kt,n1)

B kt+1=g(kt,n0)

!

!

E0

A

!

k0 k(n0) k(n1) kt

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 53

Extensions

• Human capital accumulation

– automatic knowledge transfer and endogenous growth

• Public investment

– macroeconomic effects

• Intergenerational accounting

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 54

• Human capital creation may be an important engine of growth in the economy

• We study an OLG version of the Lucas-Uzawa model (also studied in Chapter 14)

proposed by Azariadis-Drazen

Households

• work full time during second period of life

• divide time between training and working during first period

• lifetime utility:

ΛY,i

t ≡ ΛY

(Ct

Y,i

, C O,i

t+1 )

– no direct utility attached to leisure and to training (knowledge not value per se)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 55

• budget identities:

O,i

Ct+1 = (1 + rt+1 )Sti + Wt+1 Ht+1

i

– Hti is the level of human capital of worker i at time t

– Nti is the amount of time spent working (rather than training) during youth

– CtY,i , Ct+1

O,i

, and Sti have their usual meaning

Eti = 1 − Nti ≥ 0

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 56

• Training technology:

i

Ht+1 = G(Eti )Hti

– positive but non-increasing returns to training (G0 > 0 ≥ G00 )

– no knowledge depreciation (G(0) = 1)

• Household optimization in two steps:

– choose training level to maximize lifetime income

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 57

• Household chooses Eti such that lifetime income is maximized:

· i

¸

i i i i Wt+1 G(Et )

It (Et ) ≡ Ht Wt (1 − Et ) +

1 + rt+1

• first-order (Kuhn-Tucker) condition:

i

· 0 i

¸

dIt i Wt+1 G (Et )

i

= Ht −Wt + ≤ 0,

dEt 1 + rt+1

µ i¶

i i dIt

Et ≥ 0, Et i

=0

dEt

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 58

– no-training solution:

0 Wt (1 + rt+1 )

G (0) < ⇒ Eti = 0

Wt+1

Corner solution because training technology not productive enough!

– training solution:

µ ¶

Wt+1

Eti >0 ⇒ 1 + rt+1 = G0 (Eti )

Wt

Invest in human capital until its yield equals the yield on financial assets.

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 59

• Household chooses CtY,i , Ct+1

O,i

and Sti in order to maximize lifetime utility subject to

the lifetime budget constraint:

O,i

C

CtY,i + t+1

= Iti ,

1 + rt+1

where Iti is now maximized lifetime income (see Step 1).

³ ´

i

Sti = S rt+1 , (1 − Eti )Wt Hti , Wt+1 Ht+1

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 60

• Initial condition for household i:

Hti = Ht

Household “inherits” average level of human capital in the economy (osmotic human

capital transfer across generations)

• Constant population (Lt = Lt−1 = 1)

• Total labour supply in efficiency units is Nt = (1 − Et )Ht + Ht

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 61

Nt = (2 − Et )Ht (d)

µ ¶

Wt+1

1 + rt+1 = G0 (Et ) (e)

Wt

Ht+1 = G(Et )Ht (f)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 62

• Model displays endogenous growth in the steady state. This is illustrated in Figure

1−²

17.5 for the unit-elastic case with technology yt = kt L and utility

ΛYt = log CtY + (1/(1 + ρ)) log Ct+1 O

.

– PB is portfolio balance line: (k, E) combinations for which yields on physical and human

capital equalize

investment

– equilibrium at E0

i

• Engine of growth in the model is the training technology Ht+1 = G(Eti )Hti

– level of training explains growth rate in human capital

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 63

PB

E0

!

SI

E

(

(=G(E)-1

!

E0

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 64

• Eckstein-Zilcha: why do we have compulsory education systems?

• Key idea: parents may under-invest in the human capital of their children (intra-family

external effect)

• Utility function:

ΛYt ≡ ΛY (CtY , Ct+1

O

, Zt , Ot+1 )

– CtY is consumption when young

O

– Ct+1 is consumption when old

– Zt is leisure during youth

– Ot+1 ≡ (1 + n)Ht+1 is total human capital of the agent’s offspring (Ht+1 is

human capital per child, 1 + n is the number of children)

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 65

– G(·) is the training curve (satisfying 0 < G(0) ≤ 1, G(1) > 1, G0 > 0 ≥ G00 )

– positive but diminishing marginal product of human capital: 0 < β ≤ 1.

– NOTE difference with A-D model: now parent chooses human capital of children

(costs and benefits accrue to different agents)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 66

– one unit is supplied inelastically to the labour market

• Household’s lifetime budget constraint:

O

Ct+1

CtY + = Wt H t

1 + rt+1

– Wt = FN (Kt , Nt ) where Nt ≡ Lt Ht (efficiency units of labour)

– rt + δ = FK (Kt , Nt )

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 67

O

, Zt , Et , and Ht+1 to maximize lifetime utility subject

to (a) the training technology, (b) the time constraint, and (c) the consolidated budget

constraint. Key first-order conditions:

∂ΛY /∂CtY

Y O

= 1 + rt+1

∂Λ /∂Ct+1

∂ΛY 0 ∂ΛY

G (Et )Htβ − < 0 =⇒ Et = 0

∂Ot ∂Zt

∂ΛY 0 ∂ΛY

G (Et )Htβ − = 0 ⇐= Et > 0 (A)

∂Ot ∂Zt

– corner solution if the net marginal benefit of training is negative

– for interior solution training provided until net marginal benefit of training is zero

(all gains exhausted)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 68

• Assume that interior solution (A) obtains. Note that (A) only contains costs and

benefits of the parent! First hint at underinvestment problem. Not all benefits are

taken into account.

• The Social Welfare Function is:

∞

X ∞

X

SW 0 ≡ λt ΛYt = λt ΛY (CtY , Ct+1

O

, Zt , Ot+1 )

t=0 t=0

– {λt }∞

t=0 is a positive monotonically decreasing sequence of weights attached to

P∞

the different generations (which satisfies t=0 λt < ∞)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 69

• resource constraint:

O

C

CtY + t + (1 + n)kt+1 = F (kt , Ht ) + (1 − δ)kt

1+n

where kt ≡ Kt /Lt

• social planner chooses sequences for consumption ({CtY }∞ t=0 and {C O

}∞

t+1 t=0 ), the

stocks of human and physical capital ({Kt+1 }∞ t=0 and {H t+1 } ∞

t=0 ), and the

educational effort ({Et }∞

t=0 ) in order to maximize SW 0 subject to (a) the training

technology, (b) the time constraint, and (c) the resource constraint.

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 70

·µ ¶

∂ΛY (x̂ t) ∂ΛY (x̂ t)

= G 0

(Êt )Ĥtβ

∂Zt ∂Ot

Ã !

∂ΛY (x̂t )

+ O

FN (k̂t+1 , Ĥt+1 )

∂Ct+1

Ã !Ã !#

β(1 + n)Ĥt+2 ∂ΛY (x̂t ) ∂ΛY (x̂t+1 )/∂Zt+1

+ 1+β O Y

G0 (Êt+1 )Ĥt+1 ∂Ct+1 ∂ΛY (x̂t+1 )/∂Ct+1

– marginal social costs (LHS) must be equated to marginal social benefits (RHS)

∗ “own” term, affecting decision maker directly (line 1)

∗ “induced” term, affecting earning power of children (line 2)

∗ “induced” term, affecting incentive of children to educate their children provide

(line 3)

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 71

• Second and third effects are ignored by parents which leads to under-investment in

human capital. Policy options:

– compulsory education

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 72

Public investment

• Empirical work by Aschauer prompts a number of questions:

– What are the macroeconomic effects of public investment?

– exogenous labour supply / lump-sum taxes

– public capital affects factor productivity (e.g. bridges, roads, airports, etc.)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 73

• Accumulation identity:

Gt+1 − Gt = ItG − δ G Gt

– Gt+1 is public capital stock

– ItG is public investment

– δ G is depreciation rate on public capital

• Technology:

Yt = F (Kt , Lt , gt )

where gt ≡ Gt /Lt

– CRTS in (Kt , Lt )

– positive but diminishing marginal product of public capital, Fg > 0, Fgg < 0

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 74

rt = r(kt , gt ) ≡ fk (kt , gt ) − δ,

Wt = W (kt , gt ) ≡ f (kt , gt ) − kt fk (kt , gt ),

where f (kt , gt )

≡ F (Kt /Lt , 1, gt ) is the intensive-form production function. By

1−² ² η

assumption, gt affects rt and Wt positively (Example: Yt = Kt L Lt L gt with

0 < η < ²L )

• Household utility: µ ¶

1

ΛYt = log CtY + O

log Ct+1

1+ρ

• Household lifetime budget constraint:

O O

T t+1 Ct+1

Ŵt ≡ Wt − TtY − = CtY +

1 + rt+1 1 + rt+1

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 75

• Savings function:

µ ¶

¡ Y

¢ O

Tt+1

St = (1 − c) Wt − Tt +c

1 + rt+1

1+ρ

where c ≡ 2+ρ

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 76

Model summary

• Model is:

(1 + n)gt+1 = iG

t + (1 − δ G )gt (a)

TtO

iG

t = TtY

+ (b)

1+n

£ ¤ O

cTt+1

Y

(1 + n)kt+1 = (1 − c) W (kt , gt ) − Tt + (c)

1 + r(kt+1 , gt+1 )

t ≡ ItG /Lt )

– (b): government budget constraint

• Immediately obvious that financing method critically affects the model: who pays for

iG

t affects (c) and thus the private capital stock and the rest of the economy

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 77

• In Figure 17.6 we consider the case in which the old are untaxed (TtO = 0 for all t)

– GE line: (g, k) combinations for which gt+1 = gt .

∗ horizontal

∗ gt rises (falls) for points above (below) the GE line–see the vertical arrows.

– KE line: (g, k) combinations for which kt+1 = kt .

∗ slope is negative (positive) for low (high) private capital stock [Intuition: slope

determined by 1 + n − (1 − c) Wk ; Wk high (low) if k is low (high)]

∗ kt increases (decreases) for points above (below) the KE line–see the

horizontal arrows.

∗ E0 : stable node (stable monotonic or cyclical adjustment)

∗ A: saddle point (unstable because both gt and kt are predetermined variables)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 78

t is increased?

effect ambiguous): k rises (falls) if iG /y < η²L (> η²L ), i.e. if public capital is

initially relatively scarce (abundant).

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 79

gt

KE: kt+1=kt

A E0

g ! ! GE: gt+1=gt

SP

A

!

0

kA k* k kt

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 80

• SWF approach in an OLG setting

• Social Welfare Function:

µ ¶−1 ∞ µ

X ¶t

1+n Y Y O 1+n

SW 0 ≡ Λ (C−1 , C0 ) + ΛY (CtY , Ct+1

O

)

1 + ρG 1 + ρG

t=0

– ρG is the planner’s discount rate (ρG > n). May or may not equal ρ.

– special treatment of current old generation to avoid dynamic inconsistency of the

social optimum (see Intermezzo)

• Resource constraint:

CtO

CtY + + (1 + n) [kt+1 + gt+1 ] = f (kt , gt ) + (1 − δ)kt + (1 − δ G )gt

1+n

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 81

t=0 , {C O ∞

}

t t=0 ), {gt+1 } ∞

t=0 , and {k t+1 } ∞

t=0 ), in order

to maximize SW 0 subject to the resource constraint, taking k0 and g0 as given.

∂ΛY (x̂t )/∂CtY

O

= 1 + r̂t+1 (a)

∂ΛY (x̂t )/∂Ct+1

r̂t+1 = fk (k̂t+1 , ĝt+1 ) − δ = fg (k̂t+1 , ĝt+1 ) − δ G (b)

∂ΛY (x̂t )/∂CtY

= 1 + ρG (c)

∂ΛY (x̂t−1 )/∂CtO

– (a): socially optimal Euler equation; MRS between present and future

consumption equated to gross interest factor

– (b): yields on private and public capital should be equalized (efficient investment)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 82

separable preferences we get:

U 0 (ĈtY )1 + ρG

=

0 O

U (Ĉt ) 1+ρ

∗ if ρG > ρ then planner ensures that U 0 (ĈtY ) > U 0 (ĈtO ) i.e. that ĈtY < ĈtO

(favour the old).

∗ if ρG = ρ then planner ensures that U 0 (ĈtY ) = U 0 (ĈtO ) i.e. that ĈtY = ĈtO

(egalitarian solution)

∗ if ρG < ρ then planner ensures that U 0 (ĈtY ) < U 0 (ĈtO ) i.e. that ĈtY > ĈtO

(favour the young).

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 83

• In the steady state, r̂t = ρG so (b) simplifies to:

Hence, modified golden rules for private and public capital accumulation feature the

social planner’s discount rate

• First-best social optimum can be decentralized if and only if the right policy

instruments are available:

– iG (and thus g ) is set correctly

– age-specific lump-sum taxes are available (even stronger requirement than in the

representative-agent model)

• If one or more of the policy variables is not available, the problem becomes a

second-best optimization problem (Ramsey taxation, modified Samuelson rule)

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 84

Intergenerational accounting

• How should we measure the government’s fiscal stance?

• Government budget deficit is fundamentally ambiguous

– how do we treat public investment

– “...every dollar the government takes in or pays out is labeled in a manner that is

economically arbitrary”

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 85

– invariant to accounting labels

– constant population (Lt−1 = Lt = 1)

– public goods for young and old (e.g. swimming pools and old-age homes)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 86

Government

• Flow budget identity

Bt+1 = (1 + rt )Bt + GO

t + GY

t − T t

O

− T t

Y

– Bt is government debt

– GO

t is pure public good provided to old (free of charge)

– TtO lump-sum tax levied on old

– TtY lump-sum tax levied on young

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 87

∞

X £ O Y

¡ ¢¤

Bt = Rt−1,τ Tt+τ + Tt+τ − GO

t+τ + GYt+τ

τ =0

τ µ

Y ¶

1

Rt−1,τ =

s=0

1 + rt+s

primary surpluses

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 88

Households

• Standard assumptions

• Key expressions:

CtY + St = Wt − TtY

Y O

Ct+1 = (1 + rt+1 )St − Tt+1

St = Bt+1 + Kt+1

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 89

O

Ct+1

CtY + = Wt − Tt,t

1 + rt+1

– Tt,t is the present value of (lump-sum) taxes that a generation born in period t

(second subscript) must pay over the course of its life seen from the perspective

of period t (first subscript):

O

T t+1

Tt,t ≡ TtY + .

1 + rt+1

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 90

Generational accounts

• The GBC can be rewritten in terms of tax bills paid by present and future generations

(see book for details):

µ ¶ µ ¶· O ¸

1 1 Tt+1

Bt = TtO + TtY +

1 + rt 1 + rt 1 + rt+1

| {z } | {z }

(a) (b)

µ ¶µ ¶· O ¸

1 1 Y Tt+2

+ Tt+1 +

1 + rt 1 + rt+1 1 + rt+2

| {z }

(c)

µ ¶µ ¶µ ¶· O ¸

1 1 1 Y Tt+3

+ Tt+2 + + ....

1 + rt 1 + rt+1 1 + rt+2 1 + rt+3

∞

X £ O Y

¤

− Rt−1,τ Gt+τ + Gt+τ

τ =0

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 91

– NOTE: all expressed in present value terms (discounted back to the end of period

t − 1)

• A more compact statement of the generational accounts is:

∞

X ∞

X

£ ¤

Bt + Rt−1,τ GO

t+τ + GY

t+τ = Tt−1,k ,

τ =0 k=t−1

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 92

µ ¶

1

Tt−1,t−1 ≡ TtO (existing old)

1 + rt

µ ¶

1

Tt−1,t ≡ Tt,t (existing young)

1 + rt

µ ¶" O

#

1 Y Tt+1

= Tt +

1 + rt 1 + rt+1

Tt−1,k ≡ Rt−1,k−1 Tk,k (future generations)

" #

O

Tk+1

= Rt−1,k−t TkY +

1 + rk+1

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 93

implementations of the generational accounting methods. In Table 17.2 we show the

male generational accounts (for the US, in 1991). Key features:

$79,000 in (PV terms)

– Row “Future”: the typical future newborn male must pay US $166,500 (compared

to US $79,000 for a newborn male in 1991)

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 94

Generation’s Net Tax Transfer

age in 1991 payments payments receipts

×$1000 ×$1000 ×$1000

0 78.9 99.3 20.4

10 125.0 155.3 30.3

20 187.1 229.6 42.5

30 205.5 258.5 53.0

40 180.1 250.0 69.9

50 97.2 193.8 96.6

60 -23.0 112.1 135.1

70 -80.7 56.3 137.0

80 -61.1 30.2 91.3

90 -3.5 8.8 12.3

Future 166.5

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 95

Discussion

• Restate some of the key points suggested by Buiter

• True, deficit is meaningless indicator

• Method of Generational Accounting also has its own problems:

– lives or dies with validity of the life-cycle model (Ricardian equivalence invalid)

• In principle one could build a CGE model to take all these effects into account.

Practice, however, will prove recalcitrant.

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 96

Punchlines

• Studied workhorse model of macroeconomics and public finance

– life-cycle saving

• Pensions

– fully funded: neutral (saving by the government)

– transitional problems

Ben J. Heijdra

Foundations of Modern Macroeconomics: Chapter 17 97

• Human capital

– osmotic transfer and growth

– mandatory education

• Public capital

– macroeconomic effects

Ben J. Heijdra

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