Friday, February 20, 2015

Is aging deflationary?

Hideki Konishi, Kozo Ueda, and Mitsuru Katagiri presented a few months ago a paper titled "Aging and deflation from a fiscal perspective." Here are the slides.

The authors build a model that combines overlapping generations, the fiscal theory of price determination, and political considerations to analyze how the price level changes with fertility and longevity.

The simplified version of the model, in section two of the paper, assumes that taxes are exogenous. This simple version, nevertheless, is enough to produce a key result:
"Aging is deflationary when caused by an increase in longevity, but inflationary when caused by a decline in birth rate." 
The reason is political considerations:
"If the birth rate declines, the resultant contraction in the tax base reduces the fiscal surplus. The government is then inclined to maintain its solvency partly by generating inflation at the cost of the older generation's well-being and partly by making the younger generation pay more taxes. In contrast, if the life expectancy increases and older persons survive longer than expected, they might face a shortage of savings for their retirement period. The government then, led by the strengthened political influence of the older generation, attempts to suppress inflation and increase the real value of the government bonds held by the older generation."
Japan has experienced both unexpected declines in fertility and unexpected increases in longevity. The deflationary effect of higher longevity, however, dominated. The authors' simulations of the model show that Japan's aging depressed inflation by 0.6 percentage points annually.

Another key result, which comes from the fiscal theory of price determination, is that our children don't pay for our deficits. The government debt at the beginning of each period is fixed in nominal terms. Today's price level changes to equate the real value of today's debt with the present value of future deficits.

A corollary of this result is that tomorrow's fiscal policy is not constrained by today's level of debt or fiscal policy. Governments are unencumbered by the deficits of their predecessors in office.

A second corollary of the fiscal independence result is that governments don't have an incentive to strategically accumulate debt. In some political economy models of fiscal policy, a government can tie the hands of a successor it dislikes, by raising debt. If the price level, however, adjusts every year to fulfill the government's inter-temporal budget constraint, strategic debt accumulation doesn't happen.

I thought this paper was a refreshing way of looking at the link between deflation and aging.


[The following list was edited on March 17, 2015.]

Other recent papers (post 2000) about this topic, in chronological order:

Fair, R. C. and K. Dominguez (1991), “Effects of the changing U.S. age distribution on macroeconomic equations”, American Economic Review, 81(5), pp 1276–94.

The effects of the changing U.S. age distribution on various macroeconomic equations are examined in this paper. The equations include consumption, money demand, housing investment, and labor force participation equations. Seven age groups are analyzed: 16-19, 20-24, 25-29, 30-39, 40- 54, 55-64, and 65+. There seems to be enough variance in the age distribution data to allow reasonably precise estimates of the effects of a number of age categories on the macro variables. The results show that, other things being equal, age groups 30-39 and 40-54 consume less than average, invest less in housing than average, and demand more money than average. Age group 55-64 consumes more and demands more money. If these estimates are right, they imply, other things being equal, that consumption and housing investment will be negatively affected in the future as more and more baby boomers enter the 30-54 age group. The demand for money will be positively affected. If, as Easterlin argues, the average wage that an age group faces is negatively affected by the percent of the population in that group, then the labor force participation rate of a group should depend on the relative size of the group. If the substitution effect dominates, people in a large group should work less than average, and if the income effect dominates, they should work more than average. The results indicate that the substitution effect dominates for women 25-54 and that the income effect dominates for men 25-54.

Lindh, T. and B. Malmberg (1998), “Age structure and inflation: A Wicksellian interpretation of the OECD data”, Journal of Economic Behavior and Organization, 36(1), pp 19-37.

Wicksell's cumulative inflation process is founded on the separation of investment and saving decisions. The demographic age structure influences the aggregate of both these decisions, and therefore should be one of the determinants behind the inflation processes. We study annual OECD data 1960–1994 using age variables to explain inflation. Panel estimations of a reduced form inflation-age model show a robust correlation consistent with the hypothesis that increases in the population of net savers dampen inflation while especially the younger retirees fan inflation as they start consuming out of accumulated pension claims. This pattern is expected from life-cycle saving but could also be due to age effects on budget deficits or on money demand. Our results are potentially important for inflation forecasts and monetary policy.

Lindh, T. and B. Malmberg (2000), “Can age structure forecast inflation trends?”, Journal of Economics and Business, 52, pp 31–49.

The demographic age structure influences the aggregate of individual economic decisions. Standard macroeconomic models imply that inflation pressure will covary with the age distribution unless accommodated by monetary policy. We estimate the relation between inflation and age structure on annual OECD data 1960–1994 for 20 countries. The result is an age pattern of inflation effects consistent with the hypothesis that increases in the population of net savers dampen inflation, whereas especially the younger retirees fan inflation as they start consuming out of accumulated pension claims. This can be explained, for example, with life-cycle saving behavior combined with a cumulative process of inflation, but other mechanisms are also consistent with the results. In any case, the results suggest that demographic projections may be useful for long- and medium-term inflation forecasts. Forecasts from our panel model catch the general downward trend in OECD inflation in the 1990s. However, useful forecasts for individual countries need to incorporate more country-specific information.

Bullard J., C. Garriga and C. J. Walker (2012), “Demographics, Redistribution, and Optimal Inflation,” Federal Reserve Bank of St. Louis Review, November/December 2012, 94(6), pp. 419–39.

The authors study the interaction among population demographics, the desire for intergenerational redistribution of resources in the economy, and the optimal inflation rate in a deterministic life cycle economy with capital. Young cohorts initially have no assets and wages are the main source of income; these cohorts prefer relatively low real interest rates, relatively high wages, and relatively high rates of inflation. Older cohorts work less and prefer higher rates of return from their savings, relatively low wages, and relatively low inflation. In the absence of intergenerational redistribution through lump-sum taxes and transfers, the constrained efficient competitive equilibrium requires optimal distortions on relative prices. The authors’ model allows the social planner to use inflation/deflation to try to achieve the optimal distortions. In the model economy, changes in the population structure are interpreted as the ability of a particular cohort to influence the redistributive policy. When older cohorts have more influence on the redistributive policy, the economy has a relatively low steady-state level of capital and a relatively low steady-state rate of inflation. The opposite happens when young cohorts have more control of policy. These results suggest that aging population structures, such as those in Japan, may contribute to observed low rates of inflation or even deflation.

Anderson, D., D. Botman and B. Hunt (2014), ”Is Japan’s Population Aging Deflationary?” IMF Working Paper 14/139, August.

Japan has the most rapidly aging population in the world. This affects growth and fiscal sustainability, but the potential impact on inflation has been studied less. We use the IMF’s Global Integrated Fiscal and Monetary Model (GIMF) and find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly makes matters worse as it leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need. Many of these factors will beset other advanced countries as well, but we find that deflation risk from aging is not inevitable as ambitious structural reforms and an aggressive monetary policy reaction can provide the offset.

Yoon, J.-W., J. Kim and J. Lee (2014), “Impact of Demographic Changes on Inflation and the Macroeconomy” IMF Working Paper 14/210 November.

The ongoing demographic changes will bring about a substantial shift in the size and the age composition of the population, which will have significant impact on the global economy. Despite potentially grave consequences, demographic changes usually do not take center stage in many macroeconomic policy discussions or debates. This paper illustrates how demographic variables move over time and analyzes how they influence macroeconomic variables such as economic growth, inflation, savings and investment, and fiscal balances, from an empirical perspective. Based on empirical findings—particularly regarding inflation—we discuss their implications on macroeconomic policies, including monetary policy. We also highlight the need to consider the interactions between population dynamics and macroeconomic variables in macroeconomic policy decisions.

Juselius, M. and Takáts, E. (2015), “Can Demography Affect Inflation and Monetary Policy?” BIS Working Paper 485, February.

Several countries are concurrently experiencing historically low inflation rates and ageing populations. Is there a connection, as recently suggested by some senior central bankers? We undertake a comprehensive test of this hypothesis in a panel of 22 countries over the 1955-2010 period. We find a stable and significant correlation between demography and low-frequency inflation. In particular, a larger share of dependents (ie young and old) is correlated with higher inflation, while a larger share of working age cohorts is correlated with lower inflation. The results are robust to different country samples, time periods, control variables and estimation techniques. We also find a significant, albeit unstable, relationship between demography and monetary policy.

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