Generational Risk – Is It a Big Deal? Simulating an 80-Period OLG Model with Aggregate Shocks

49 Pages Posted: 1 Jul 2017

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 13, 2017

Abstract

The theoretical literature presumes generational risk is large enough to merit study and that such risk can be meaningfully shared via appropriate government policy. This paper questions 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. Depending on our yardstick, generational risk, whether across non-overlapping generations or across overlapping generations, is either modest or very small. A one-period bond market is effective in reducing the modest risk facing overlapping generations, indeed more effective than Social Security. But a bond market, with or without Social Security, induces younger age groups to take on riskier portfolios, exacerbating the limited risk facing non-overlapping generations. Our framework is bare bones (isoelastic preferences and Cobb-Douglas technology) with 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 model reproduces the variability of the return to aggregate U.S. wealth. With an extra ingredient, namely increasing costs of borrowing, our model reproduces the economy’s risk premium (the mean return on aggregate wealth less the mean return to safe assets). Yet this addition to the model has essentially no impact on either the economy’s fundamentals or its generational risk. While technologically-induced generational risk is minor, policy-induced generational risk is not. As we show, the unexpected introduction of pay-go Social Security (and, by implication, other intergenerational redistribution policies) represents a major generational risk.

Keywords: Intergenerational Risk Sharing, Government Transfer Policies, Aggregate Shocks, Equity Premium, Incomplete Markets, Stochastic Simulation

JEL Classification: E21, E24, E62, H55, H31, D91, D58, C63, C68

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 13, 2017). Available at SSRN: https://ssrn.com/abstract=2994899 or http://dx.doi.org/10.2139/ssrn.2994899

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

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Moscow, 125993
Russia

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