M210: Macroeconomics II

Overlapping Generations
Tiago V. de V. Cavalcanti1
1 University

of Cambridge

This Lecture (Overview):

1. Demographics and Endowments
2. Technology and Production
3. Household Behaviour
4. Equilibrium
5. Dynamics of Economy
6. Dynamic Inefficiency and Golden Rule
7. Policies in the OG framework

Main Reading:

Acemoglu (2009): Chapter 9;

Blanchard and Fischer (1989): Chapter 3.1

la Croix and Michel (2002): Chapter 1

Romer (2006): Chapter 2, Part B

Overlapping Generations

Demographics and Endowments:

Time is discrete and the economy lives forever (t = 0, 1, 2, ...).

Individuals live for 2 periods only: Young and Old. In each

period there are two types of agents:Young and Old Overlapping Generations. Heterogeneity!

At time t, Lt individuals born and population grows at rate n:

Lt = (1 + n)Lt1 .

Young individuals supply 1 unit of labour and make decisions:

consumption/savings. Old consume savings plus interest.

Technology and Production:

1. Production Technology:
Yt = F(Kt , At Lt ),
where F(.) satisfies the INADA conditions.
2. Assume At+1 /At = (1 + g) (exogenous) and capital fully
depreciates after use.
3. Markets are competitive firms are price takers:
4. FOCs as in Ramsey model:
rKt =

Yt
Kt

= FK (Kt , At Lt ) = f (kt )

wt =

Yt
Lt

= FL (Kt , At Lt ) = At [f (kt ) kt f (kt )],

where k K/(AL) = capital per effective labor units.

Households

Young individuals problem: Choose c1t , c2t+1 , and st to

maximize:
Vt =

max u(c1t ) + u(c2t+1 ), (0, 1)

c1t ,c2t+1

(1)

u (.) > 0, u (.) < 0, lim u (c) = , lim u (c) = 0

c

c0

subject to:

c1t + st = wt

b.c. for young at t

c2t+1 = (1 + rt+1 )st b.c. for old at t + 1

Note double subscript: generation and time.

Alternatively, write present value b.c.

c1t +

1
c2t+1 = wt ,
1 + rt+1

Solution of the Households Problem

L = u(c1t ) + u(c2t+1 ) + [wt (c1t +

1
c2t+1 )]
1 + rt+1

FOCs:
u (c1t ) =
u (c2t+1 ) =

1 + rt+1

Combining FOCs gives Euler equation:

u (c1t ) = (1 + rt+1 )u (c2t+1 ), and
c1t +

1
c2t+1 = wt ,
1 + rt+1

(2)
(3)

Isoelastic Utility Function: u(c) (c1 1)/(1 )

c2t+1
1
= ((1 + rt+1 ))1/ , =
c1t
1+
1 + rt+1 >
increasing
if
decreasing
1 + rt+1 <

(4)

Consumption {

determines sensitivity of consumption growth (remember 1/

= intertemporal elasticity of substitution).

Combining budget constraint (3) and Euler equation (4):

c1t =

1
1

1 + (1 + rt+1 )

wt

Savings function
1

1
1
1+ (1+rt+1 )
1

Savings functions: st =

(1+rt+1 )

wt = s(1 + rt+1 )wt

Saving rate:
1

s(1 + rt+1 ) =

(1 + rt+1 )
1

1 + (1 + rt+1 )

and c1t = [1 s(1 + rt+1 )] wt .

ds/dr > 0 iff d(1 + r)(1)/ /dr =

1
(1

ds/dr > 0
<1
SE stronger
ds/dr = 0 log utility
SE = IE .
ds/dr < 0
>1
IE stronger

+ r) 2 > 0:

(5)

Equilibrium

Goods market:
L c + L c + It = Ct + It = Yt = F(Kt , At Lt )
| t 1t {z t1 2t}

Aggregate Consumption

Capital market: aggregate savings = Investment

It = Lt st .

Thus capital stock in t + 1 equals amount saved by young in t :

Kt+1 = Lt s(1 + rt+1 )wt .

Equilibrium...

Kt+1 = Lt s(1 + rt+1 )wt .

By arbitrage: 1 + rt+1 = rKt+1 = f (kt+1 ).

Recall that: wt = At [f (kt ) f (kt )kt ].

Kt+1 = Lt s(f (kt+1 ))At [f (kt ) f (kt )kt ].

Dividing both sides by Lt+1 At+1 gives:

kt+1 =

1
s(f (kt+1 ))[f (kt ) f (kt )kt ].
(1 + n)(1 + g)

(6)

Dynamics of Economy: General Case

kt+1 =

With no further assumptions, difficult to say much.

1
s(f (kt+1 ))[f (kt ) f (kt )kt ].
(1 + n)(1 + g)

Since (from Inada conditions) f (.) 0 as k , kt+1

eventually less than kt .
Unbounded growth not possible, labor effectiveness only
source of long-run growth.

BUT: Model allows for multiple steady states depending on

the production function.

If production is Cobb-Douglas, then unique steady state.

If not, then various possibilities depending on how f and
parameters of the model, i.e. interact.

Dynamics of Economy: Cobb-Douglas and log utility

Special case: log utility ( = 1) and

Y = K (AL)1 f (k) = k .

Savings rate (5) becomes /(1 + ) and

[f (k) f (k)k] = (1 )k .

Equation of motion (6) becomes:

kt+1 =

(1 )kt Dkt ,
(1 + n)(1 + g) 1 +

D=

(1 ).
(1 + n)(1 + g) 1 +

Point: Balanced growth path equilibrium is globally stable

(7)

Dynamics of Economy: Cobb-Douglas and log utility

Economy behaves like Solow/Ramsey economies on balanced

growth path (BGP): savings rate constant, output grows at rate g,
capital/output ratio constant...

Response to shocks: A rise in the discount factor, , causes

young to save more kt+1 -schedule shifts up.

Similar effects as in Solow model: output and capital per

effective worker permanently higher, but only transitory
increases in growth rates.

Golden Rule and Dynamic Inefficiency

To simplify the math, assume g = 0:

Aggregate resource constraint (RC):

F(Kt , Lt ) = Kt+1 + Lt c1t + Lt1 c2t

Aggregate consumption
Ct = c1t Lt + c2t Lt1 = c1t Lt +

Divide RC by Lt
f (kt ) = (1 + n)kt+1 + c1t +

1
c2t Lt
1+n

1
c2t
1+n

In steady state
f (k ) = (1 + n)k + c = c = f (k ) (1 + n)k

Golden Rule and Dynamic Inefficiency

Golden rule: maxk c = f (k ) (1 + n)k

f (kGR ) = 1 + n

It might happen that k > kGR , e.g.

Cobb-Douglas and log utility

1
 1

(1 )
k =
(1 + n)(1 + )
1
 1


kGR =
1+n

Dynamic inefficiency occurs when

(1 )
(1 )
>

>
(1 + n)(1 + )
1+n
(1 + )

Dynamic inefficiency more likely when:

is large
capital share is small

Golden Rule and Dynamic Inefficiency: Why?

How can equilibrium with optimising agents, competitive

markets and no externalities be Pareto-inefficient?
1. In Ramsey model, households problem equivalent to social
planners problem
2. In Diamond model, households problem not equivalent to
social planners problem.

Infinite number of agents allows planner to redistribute

consumption between generations; this redistribution not
available to decentralized economy.

Reduction of 1 unit of consumption of young gives (1 + n)

units of consumption to old. Planner can enforce same
contract to be applied to all future generations and make
everyone happier.

Is dynamic inefficiency relevant? Studies conclude that big

economies such as US or Japan, are dynamically efficient
(Abel et al, 1989).

Government in the Diamond Model I

In Diamond model, study two roles of the government:

Raises revenue to finance its expenditures

Acts as a planner who redistributes wealth over generations

Consider Cobb-Douglas and log-utility case, and assume

no tech progress g = 0

Government in the Diamond Model II

Recall

Ut


1
1
ln c2t+1 , =
= max ln c1t +
1+
1+
c1t + st = wt
b.c. for young at t
s.t.
c2t+1 = (1 + rt+1 )st b.c. for old at t + 1


We found Euler equation

c2t+1
1 + rt+1

1
1
=
, st =
wt =
wt and s =
c1t
1+
1+
2+
2+
Also, tomorrows capital = young peoples savings
Kt+1 = Lt st = (1 + n)kt+1 = st
In equilibrium
kt+1 =

1
1
s
wt =

(1 )kt
1+n
1+n 2+

(8)

Lump-sum taxation of young

Aggregate government spending Gt = Tt = t Nt (balanced

budget)

After tax income = net income: wt t

Capital per capita becomes

kt+1 =

s
(wt t )
1+n

(9)

Individuals reduce c1 by less than one-for-one savings

Steady state drops and rental rate of capital goes up

kt+1 =

1
Gt
1

[(1 )kt gt ], where gt =

(1 + n) 2 +
Nt

Lump-sum taxation distortionary in OLG framework

Lump-sum taxation and bond financing of young I

Government can issue debt b B/(L) as well as

lump-sum taxes to finance G.

Bonds can be viewed as assets in the same way that

capital is an asset = return on bonds should be the
same as the one on capital.
1. Young individuals save using capital and bonds. LHS of (9)
becomes kt+1 + bt+1 .
2. Government need not run balanced budget.

Dynamics of capital:
kt+1 + bt+1 =
kt+1 =

s
(wt t )
(10)
1+n
1
1

[(1 )kt t ] bt+1

1+n 2+

Lump-sum taxation and bond financing of young II

Governments budget constraint becomes

Gt
|{z}

gov spending

+ (1 + rt )Bt =
| {z }
bond repayments

Tt
|{z}

tax revenues

Bt+1
|{z}

bond revenues

In per-capita terms
gt + (1 + rt )bt = t + (1 + n)bt+1

(11)

Experiment: Keep g and everything else fixed, but reduce

taxes by one unit and increase bt+1 accordingly. From (11)




1
0 = t t + (1 + n) bt+1 bt+1 = bt+1 bt+1 =
1+n
| {z }
= 1

Lump-sum taxation and bond financing of young III

Effect on capital

kt+1

=
=



1
1
1

[(1 )kt (t 1)] bt+1 +

1+n 2+
1+n




1
1
1
1

[(1 )kt t ] bt+1 +

1
1+n 2+
1+n 2+
{z
}
|
kt+1

= kt+1
kt+1

1
1+n

1
2+


1 < 0

Capital per capita falls because of bond financing instead

of tax financing
Taxes postponed for future generations
Current young taxed less = consume more = less
savings
Increase in debt can be used to lower capital stock and
achieve golden rule (dynamic inefficiency) =bonds
redistribute resources between young and old

Social Security I

Problem:
max

c1t ,c2t+1 ,st

u(c1t ) +


1
u(c2t+1 ) , subject to
1+

c1t + st = wt , c2t+1 = (1 + rt+1 )st .

Equilibrium in decentralised economy:

u (wt st ) =

1 + rt+1
u [(1 + rt+1 )st ]
1+

st = (1 + n)kt+1
wt = f (kt ) kt f (kt )
1 + rt = f (kt )

(12)
(13)

Social Security II

Social security contribution of young at t : dt

Benefit received when old at t : bt

Two polar cases:

1. Fully funded: when old get back amount deposited when
young with full interest
bt = (1 + rt )dt1 ,
with rate of return rt
2. Pay-as-you-go: when old get your share of the contributions
of the young
Lt1 bt = Lt dt = bt = (1 + n)dt
with rate of return n.

Note: in practice many social security systems unfunded

Fully funded social security system

Government raises dt , invests aggregate contributions as

capital, and pays bt = (1 + rt )dt1 to each old individual
Problem Fully Funded

Euler and savings equations (12) and (13) become:

u [wt (st + dt )] =

1 + rt+1
u [(1 + rt+1 )(st + dt )] ,
1+

st + dt = (1 + n)kt+1

Compare this to original eqs. (12) and (13) and note the
same kt solves both systems [If dt < (1 + n)kt+1 ]

Fully funded social security has no effect on total savings

and capital accumulation

Individuals indifferent about who saves, since the return is

the same

Pay-as-you-go social security system

We have bt = (1 + n)dt

Euler and savings equations (12) and (13) become:

u [wt (st + dt )] =

Problem PAYG

1 + rt+1
u [(1 + rt+1 )st + (1 + n)dt )] ,
1+

st = (1 + n)kt+1

PAYG system is a transfer from young to old.

From individuals viewpoint, unfunded social security like

saving at rate n instead of r. When d forced savings
increase and private savings fall

From societys viewpoint, revenues are redistributed to old,

not invested. total savings

Pay-as-You-Go system can be welfare improving if

economy was dynamically inefficient, f (k ) < n.

Bequest Motive and Ricardian Equivalence I

So far, we assumed life-cycle consumers care only about

their own welfare and leave no bequests.

Now: Each gener. cares about utility of next gener. Let

utility of generation born at time t be Vt :
Vt = u(c1t ) +

1
1
u(c2t+1 ) +
Vt+1
1+
1+

(14)

Why 1/(1 + )? [BX] assume:

1
1+n
=
1+
(1 + ) (1 + )

(15)

(1 + n) Utility is multiplied by the number of descendants

(1 + ) Utility is comparable with the utility when old
(1 + ) captures the "selfishness" of the parent: the larger
is, the more selfish the individual is

Bequest Motive and Ricardian Equivalence II

Solve (14) recursively forward:


X
i
(1 + )
Vt =
u(c1t+i ) +
i=0


1
u(c2t+i+1 )
1+

Budget constraint modified to take into account bequests:

c1t + st = wt + bt

(16)

c2t+1 + (1 + n)bt+1 = (1 + rt+1 )st ,

where bt is bequest received by each member of

generation t. Bequest must be non-negative.

Bequest Motive and Ricardian Equivalence III

Factor market equilibrium unchanged
1 + rt = rKt = f (kt ), and wt = f (kt ) kt f (kt ).
Maximising (14) s.t. (16) gives
u (c1t ) =

FOCs

for st and bt+1 > 0:

1 + rt+1
u (c2t+1 )
1+

1
1+n
u (c2t+1 ) =
u (c1t+1 ),
1+
1+

(Euler)
(Bequest)

If bt+1 > 0, then steady state c1t = c1t+1 implies:

(15)

(1 + r ) = (1 + n)(1 + ) = (1 + r ) = (1 + ) (1 + )
If individuals are completely altruistic ( = 0) then r =
=OLG Altruist model behaves like Ramsey model
=Economy can never be dynamically inefficient

Ricardian equivalence

How do bequests affect social security?

Pay-as-you-go is like intergenerational transfers from young to

old imposed by government

Bequests are like willing intergenerational transfers from old

to young (due to utility)

If pay-as-you-go is introduced by government, old will

simply increase bequests to offset the effect and produce
exactly same allocation as before

Social security has no effect on capital accumulation if the

market economy has operative bequest motive

Example of Ricardian equivalence in which government

fiscal actions completely offset by private sector responses

Government and Fiscal Policy: Summary

Can a government improve social welfare?
1. Infinite horizon models (without externalities, public
goods) no
2. OLG models (without externalities, public goods)
sometimes

Issuing debt yes

Taxing/subsidising capital yes, but not necessary
Integenerational transfers yes
Social security

Fully funded no
Pay-as-you-go: without bequests yes - with bequests
no

Some Concluding Remarks from Growth Models with

Exogenous Growth
1. Simple and tractable frameworks, which allow us to discuss
capital accumulation and the short and long run implications of
policies.
2. Increases in investment rates of either human or physical capital
increase steady state level of y, but not growth rate;
3. The models show us that if there is no technological progress
there will be no sustained growth even with human capital.
4. Generate per capita output growth, but only exogenously:
technological progress is a black box.
5. Why do countries have different savings rate, policies, and
institutions?
6. Need to dig deeper and understand what lies in these black
boxes.

Social Security: Fully Funded

Households problem with a fully funded social security

system:


1
max u(c1t ) +
u(c2t+1 ) , subject to
c1t ,c2t+1 ,st
1+
c1t + st = wt dt ,
c2t+1 = (1 + rt+1 )st + (1 + rt+1 )dt .

Back

Social Security: PAYG

Households problem with a PAYG social security system:



1
u(c2t+1 ) , subject to
max u(c1t ) +
c1t ,c2t+1 ,st
1+
c1t + st = wt dt ,
c2t+1 = (1 + rt+1 )st + (1 + n)dt .

Back

Bequest Motive and Ricardian Equivalence

Problem
h
i
P
1
i u(c
)
+
(1
+
)
u(c
)
,
maxc1t+i ,c2t+i+1 ,st ,bt+1
1t+i
2t+i+1
i=0
1+
Subject to
c1t + st = wt + bt , c2t+1 + (1 + n)bt+1 = (1 + rt+1 )st ,
Lagrange:

L=

X
i=0



1
1
u((1 + rt+1 )st (1 + n)bt+1 ) .
u(wt + bt st ) +
(1 + )
1+

FOCs:

st : u (c1 t) +

1
1
u (c2t+1 ) = 0 u (c1 t) =
u (c2t+1 ),
1+
1+

bt+1 :
Back

(1 + n)
1
u (c2t+1 ) +
u (c1t+1 ) = 0.
1+
(1 + )