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

  • Jasmina Hasanhodzic
  • Laurence J. Kotlikoff

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. Ball, Laurence & Mankiw, N. Gregory, 2007. "Intergenerational Risk Sharing in the Spirit of Arrow, Debreu, and Rawls, with Applications to Social Security Design," Scholarly Articles 3443106, Harvard University Department of Economics.
  2. Furlanetto, Francesco & Seneca, Martin, 2014. "New Perspectives On Depreciation Shocks As A Source Of Business Cycle Fluctuations," Macroeconomic Dynamics, Cambridge University Press, vol. 18(06), pages 1209-1233, September.
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  7. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity in the Macroeconomy," GSIA Working Papers 1997-37, Carnegie Mellon University, Tepper School of Business.
  8. Krusell, Per & Smith, Anthony A., 1997. "Income And Wealth Heterogeneity, Portfolio Choice, And Equilibrium Asset Returns," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 387-422, June.
  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. Serguei Maliar & Lilia Maliar & Kenneth Judd, 2010. "Numerically Stable Stochastic Simulation Approaches for Solving Dynamic Economic Models," 2010 Meeting Papers 280, Society for Economic Dynamics.
  11. Kenneth L. Judd & Lilia Maliar & Serguei Maliar, 2011. "Numerically stable and accurate stochastic simulation approaches for solving dynamic economic models," Quantitative Economics, Econometric Society, vol. 2(2), pages 173-210, 07.
  12. Krueger, Dirk & Kubler, Felix, 2004. "Computing equilibrium in OLG models with stochastic production," Journal of Economic Dynamics and Control, Elsevier, vol. 28(7), pages 1411-1436, April.
  13. 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, vol. 35(2), pages 229-239, February.
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  15. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
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