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

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  • Jasmina Hasanhodzic
  • Laurence J. Kotlikoff

Abstract

The theoretical literature on generational risk assumes that this risk is large and that the government can effectively share it. To assess these assumptions, this paper calibrates and simulates 80-period, 40-period, and 20-period overlapping generations (OLG) life-cycle models with aggregate productivity shocks. Previous solution methods could not handle large-scale OLG models such as ours due to the well-known curse of dimensionality. The prior state of the art uses sparse-grid methods to handle 10 to 30 periods depending on the model's realism. Other methods used to solve large-scale, multi- period life-cycle models rely on either local approximations or summary statistics of state variables. We employ and extend a recent algorithm by Judd, Maliar, and Maliar (2009, 2011), which restricts the state space to the model's ergodic set. This limits the required computation and effectively banishes the dimensionality curse in models like ours. We find that intrinsic generational risk is quite small, that government policies can produce generational risk, and that bond markets can help share generational risk. We also show that a bond market can mitigate risk-inducing government policy. Our simulations produce very small equity premia for three reasons. First, there is relatively little intrinsic generational risk. Second, aggregate shocks hit both the young and the old in similar ways. And third, artificially inducing risk between the young and the old via government policy elicits more net supply as well as more net demand for bonds, by the young and the old respectively, leaving the risk premium essentially unchanged. Our results hold even in the presence of rare disasters, very high risk aversion, persistent productivity shocks, and stochastic depreciation. They echo other findings in the literature suggesting that macroeconomic fluctuations are too small to have major microeconomic consequences.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19179.

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Date of creation: Jun 2013
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Handle: RePEc:nbr:nberwo:19179

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  1. Martin L. Weitzman, 2007. "Subjective Expectations and Asset-Return Puzzles," American Economic Review, American Economic Association, American Economic Association, vol. 97(4), pages 1102-1130, September.
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  3. Dirk Krueger & Felix Kubler, 2006. "Pareto-Improving Social Security Reform when Financial Markets are Incomplete!?," American Economic Review, American Economic Association, American Economic Association, vol. 96(3), pages 737-755, June.
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  7. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity, Portfolio Choice, and Equilibrium Asset Returns," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 1997-45, Carnegie Mellon University, Tepper School of Business.
  8. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  9. Zvi Bodie & Robert C. Merton & William F. Samuelson, 1992. "Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model," NBER Working Papers 3954, National Bureau of Economic Research, Inc.
  10. Laurence Ball & N. Gregory Mankiw, 2001. "Intergenerational Risk Sharing in the Spirit of Arrow, Debreu, and Rawls, with Applications to Social Security Design," NBER Working Papers 8270, National Bureau of Economic Research, Inc.
  11. Malin, Benjamin A. & Krueger, Dirk & Kubler, Felix, 2011. "Solving the multi-country real business cycle model using a Smolyak-collocation method," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 35(2), pages 229-239, February.
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  13. Francesco Furlanetto & Martin Seneca, 2011. "New perspectives on depreciation shocks as a source of business cycle fluctuations," Working Paper, Norges Bank 2011/02, Norges Bank.
  14. Kenneth L. Judd & Lilia Maliar & Serguei Maliar, 2011. "Numerically stable and accurate stochastic simulation approaches for solving dynamic economic models," Quantitative Economics, Econometric Society, Econometric Society, vol. 2(2), pages 173-210, 07.
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Cited by:
  1. Daniel Harenberg & Alexander Ludwig, 2014. "Social Security and the Interactions Between Aggregate and Idiosyncratic Risk," CER-ETH Economics working paper series 14/193, CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich.
  2. Harenberg, Daniel & Ludwig, Alexander, 2014. "Social security and the interactions between aggregate and idiosyncratic risk," SAFE Working Paper Series 59, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.

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