Lecture 8 - Overlapping Generations PDF
Lecture 8 - Overlapping Generations PDF
Daron Acemoglu
MIT
Problems of In…nity I
ui = cii + cii+1 ,
Problems of In…nity II
Proof:
At p̄, each household has income equal to 1.
Therefore, the budget constraint of household i can be written as
cii + cii+1 1.
Problems of In…nity IV
Problems of In…nity V
Proof of Proposition
Consider the following reallocation of ω: endowment of household
i 1 is given to household i 1.
At the new endowment vector ω ~ , household i = 0 has one unit of good
j = 0 and one unit of good j = 1.
Other households i have one unit of good i + 1.
At the price vector p̄, household 0 has a budget set
c00 + c11 2,
thus chooses c00 = c10 = 1.
All other households have budget sets given by
cii + cii+1 1,
Thus it is optimal for each household i > 0 to consume one unit of
the good cii+1
Thus x̃ is a competitive equilibrium.
Daron Acemoglu (MIT) Economic Growth Lecture 8 November 22, 2011. 8 / 53
The Baseline OLG Model Environment
L (t ) = (1 + n )t L (0) . (2)
Y (t ) = F (K (t ) , L (t )) .
Assume that δ = 1.
k K /L, f (k ) F (k, 1), and the (gross) rate of return to saving,
which equals the rental rate of capital, is
1 + r (t ) = R (t ) = f 0 (k (t )) , (3)
w (t ) = f (k (t )) k (t ) f 0 (k (t )) . (4)
Consumption Decisions I
subject to
c1 ( t ) + s ( t ) w (t )
and
c2 ( t + 1 ) R (t + 1) s (t ) ,
Old individuals rent their savings of time t as capital to …rms at time
t + 1, and receive gross rate of return R (t + 1) = 1 + r (t + 1)
Second constraint incorporates notion that individuals only spend
money on their own end of life consumption (no altruism or bequest
motive).
Daron Acemoglu (MIT) Economic Growth Lecture 8 November 22, 2011. 12 / 53
The Baseline OLG Model Consumption Decisions
Consumption Decisions II
s (t ) = s (w (t ) , R (t + 1)) , (6)
S (t ) = s (t ) L (t ) ,
K (t + 1) = L (t ) s (w (t ) , R (t + 1)) . (7)
Equilibrium I
De…nition A competitive equilibrium can be represented by a sequence
of aggregate capital stocks, individual consumption and
factor prices,
fK (t ) , c1 (t ) , c2 (t ) , R (t ) , w (t )gt∞=0 , such that the factor
price sequence fR (t ) , w (t )gt∞=0 is given by (3) and (4),
individual consumption decisions fc1 (t ) , c2 (t )gt∞=0 are
given by (5) and (6), and the aggregate capital stock,
fK (t )gt∞=0 , evolves according to (7).
Steady-state equilibrium de…ned as usual: an equilibrium in which
k K /L is constant.
To characterize the equilibrium, divide (7) by
L(t + 1) = (1 + n ) L (t ),
s (w (t ) , R (t + 1))
k (t + 1) = .
1+n
Daron Acemoglu (MIT) Economic Growth Lecture 8 November 22, 2011. 15 / 53
The Baseline OLG Model Equilibrium
Equilibrium II
s (f (k (t )) k (t ) f 0 (k (t )) , f 0 (k (t + 1)))
k (t + 1) = (8)
1+n
This is the fundamental law of motion of the overlapping generations
economy.
A steady state is given by a solution to this equation such that
k (t + 1) = k (t ) = k , i.e.,
s (f (k ) k f 0 (k ) , f 0 (k ))
k = (9)
1+n
Since the savings function s ( , ) can take any form, the di¤erence
equation (8) can lead to quite complicated dynamics, and multiple
steady states are possible.
Daron Acemoglu (MIT) Economic Growth Lecture 8 November 22, 2011. 16 / 53
The Baseline OLG Model Special Cases
Suppose that the utility functions take the familiar CRRA form:
!
c1 ( t ) 1 θ 1 c2 ( t + 1 ) 1 θ 1
U (t ) = +β , (10)
1 θ 1 θ
f (k ) = k α
w (t )
s (t ) = , (12)
ψ (t + 1)
where
1/θ (1 θ )/θ
ψ (t + 1) [1 + β R (t + 1) ] > 1,
Ensures that savings are always less than earnings.
s (t )
k (t + 1) = (13)
(1 + n )
w (t )
= ,
(1 + n ) ψ (t + 1)
Or more explicitly,
f (k (t )) k (t ) f 0 (k (t ))
k (t + 1) = (1 θ )/θ
(14)
1/θ 0
(1 + n ) [1 + β f (k (t + 1)) ]
The steady state then involves a solution to the following implicit
equation:
f (k ) k f 0 (k )
k = .
(1 + n) [1 + β 1/θ f 0 (k ) (1 θ )/θ ]
Daron Acemoglu (MIT) Economic Growth Lecture 8 November 22, 2011. 20 / 53
The Baseline OLG Model Special Cases
Canonical Model I
Canonical Model II
c2 ( t + 1 )
= βR (t + 1)
c1 ( t )
β
s (t ) = w (t ) , (19)
1+β
k(t+1)
45°
k*
k(t)
0 k(0) k* k’(0)
Canonical Model IV
Overaccumulation I
βS is the discount factor of the social planner, which re‡ects how she
values the utilities of di¤erent generations.
Overaccumulation II
F (K (t ) , L (t )) = K (t + 1) + L (t ) c1 (t ) + L (t 1 ) c2 ( t ) .
c2 ( t )
f (k (t )) = (1 + n) k (t + 1) + c1 (t ) + .
1+n
Overaccumulation III
Overaccumulation IV
Overaccumulation V
Now if k > kgold , then ∂c /∂k < 0: reducing savings can increase
(total) consumption for everybody.
If this is the case, the economy is referred to as dynamically
ine¢ cient— it involves overaccumulation.
Another way of expressing dynamic ine¢ ciency is that
r < n,
Overaccumulation VI
∆c (T ) = (1 + n) ∆k > 0
∆c (t ) = f 0 (k ∆k ) (1 + n) ∆k for all t > T
Interpretation
Further Intuition
Complementary intuition:
Dynamic ine¢ ciency arises from overaccumulation.
Results from current young generation needs to save for old age.
However, the more they save, the lower is the rate of return and may
encourage to save even more.
E¤ect on future rate of return to capital is a pecuniary externality on
next generation
If alternative ways of providing consumption to individuals in old age
were introduced, overaccumulation could be ameliorated.
subject to
c1 ( t ) + s ( t ) + d ( t ) w (t )
and
c2 ( t + 1 ) R (t + 1) (s (t ) + d (t )) ,
for a given choice of d (t ) by the government.
Notice that now the total amount invested in capital accumulation is
s (t ) + d (t ) = (1 + n ) k (t + 1).
Daron Acemoglu (MIT) Economic Growth Lecture 8 November 22, 2011. 38 / 53
Overaccumulation and Policy Fully Funded Social Security
subject to
c1 ( t ) + s ( t ) + d ( t ) w (t )
and
c2 ( t + 1 ) R (t + 1) s (t ) + (1 + n ) d (t + 1) ,
for a given feasible sequence of Social Security payment levels
fd (t )gt∞=0 .
Rate of return on Social Security payments is n rather than
r (t + 1) = R (t + 1) 1, because unfunded Social Security is a pure
transfer system.
Daron Acemoglu (MIT) Economic Growth Lecture 8 November 22, 2011. 41 / 53
Overaccumulation and Policy Unfunded Social Security
subject to
ci (t ) + bi (t ) yi ( t ) w (t ) + R (t ) bi (t 1) , (23)
where yi (t ) denotes the income of this individual.
Equilibrium wage rate and rate of return on capital
w (t ) = f (k (t )) k (t ) f 0 (k (t )) (24)
R (t ) = f 0 (k (t )) (25)
Capital-labor ratio at time t + 1 is:
Z 1
k (t + 1) = bi (t ) di, (26)
0
βw
b = . (30)
1 + β (1 R )
R = f 0 (k )
f (k )
<
k
1+β
= ,
β
Second line exploits the strict concavity of f ( ) and the last line uses
the de…nition of k from (29).
Daron Acemoglu (MIT) Economic Growth Lecture 8 November 22, 2011. 51 / 53
OLG with Impure Altruism Impure Altruism
Conclusions
Overlapping generations of the more realistic than in…nity-lived
representative agents.
Models with overlapping generations fall outside the scope of the
First Welfare Theorem:
they were partly motivated by the possibility of Pareto suboptimal
allocations.
Equilibria may be “dynamically ine¢ cient” and feature
overaccumulation: unfunded Social Security can ameliorate the
problem.
Declining path of labor income important for overaccumulation, and
what matters is not …nite horizons but arrival of new individuals.
Overaccumulation and Pareto suboptimality: pecuniary externalities
created on individuals that are not yet in the marketplace.
Not overemhasize dynamic ine¢ ciency: major question of economic
growth is why so many countries have so little capital.
Daron Acemoglu (MIT) Economic Growth Lecture 8 November 22, 2011. 53 / 53