Generational Risk - is it a Big Deal?: Simulating an 80-Period OLG Model with Aggregate Shocks

42 Pages Posted: 29 Jun 2013 Last revised: 29 May 2022

See all articles by Jasmina Hasanhodzic

Jasmina Hasanhodzic

Babson College - Finance Division

Laurence J. Kotlikoff

Boston University - Department of Economics; National Bureau of Economic Research (NBER); Gaidar Institute for Economic Policy

Multiple version iconThere are 3 versions of this paper

Date Written: June 2013

Abstract

The theoretical literature presumes generational risk is large enough to merit study and that such risk can be meaningfully shared via appropriate government policies. This paper assesses these propositions. It develops an 80-period OLG model to directly measure generational risk and the extent to which it can be mitigated via financial markets or Social Security. The model is trend stationary as is common in the literature. It features isoelastic preferences, moderate risk aversion, Cobb-Douglas technology, and shocks to both TFP and capital depreciation. Our computation method builds on Marcet (1988), Marcet and Marshall (1994), and Judd, Maliar, and Maliar (2009, 2011), who overcome the curse of dimensionality by limiting a model's state space to its ergodic set. Our baseline calibration uses the literature's estimate of the TFP shock process and sets depreciation shocks to match the variability of the return to U.S. wealth. The baseline results feature higher than observed output variability. Nonetheless, we find relatively little generational risk. This calibration produces a very small risk premium. Resolving this puzzle by adding increasing borrowing costs does not affect our conclusions regarding the size of generational risk. Our second calibration increases depreciation shocks, as in Krueger and Kubler (2006), to match the model's return variability with that of the equity market. Doing so reproduces the equity premium (even absent borrowing costs), but substantially overstates the variability of output and wages. This calibration generates significant cross-generational risk. Under both calibrations, the one-period bond market is very effective in sharing risks among contemporaneous generations. But the simulated sizes of short and long bond positions associated with unrestricted use of this market appear unrealistically large. Finally, we find that Social Security can be effective in reducing generational risk no matter its initial size.

Suggested Citation

Hasanhodzic, Jasmina and Kotlikoff, Laurence J., Generational Risk - is it a Big Deal?: Simulating an 80-Period OLG Model with Aggregate Shocks (June 2013). NBER Working Paper No. w19179, Available at SSRN: https://ssrn.com/abstract=2287038

Jasmina Hasanhodzic (Contact Author)

Babson College - Finance Division ( email )

Babson Park, MA 02457-0310
United States

Laurence J. Kotlikoff

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States
617-353-4002 (Phone)
617-353-4449 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Gaidar Institute for Economic Policy

Gazetny per. 5-3
Moscow, 125993
Russia

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