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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 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

  • Jasmina Hasanhodzic & Laurence J. Kotlikoff, 2013. "Generational Risk - Is It a Big Deal?: Simulating an 80-Period OLG Model with Aggregate Shocks," NBER Working Papers 19179, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:19179
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    References listed on IDEAS

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    1. Kjetil Storesletten & Chris Telmer & Amir Yaron, 2007. "Asset Pricing with Idiosyncratic Risk and Overlapping Generations," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(4), pages 519-548, October.
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    Cited by:

    1. Arellano, Cristina & Maliar, Lilia & Maliar, Serguei & Tsyrennikov, Viktor, 2016. "Envelope condition method with an application to default risk models," Journal of Economic Dynamics and Control, Elsevier, vol. 69(C), pages 436-459.
    2. Seth G. Benzell & Eugene Goryunov & Maria Kazakova & Laurence J. Kotlikoff & Guillermo LaGarda & Kristina Nesterova & Andrey Zubarev, 2015. "Simulating Russia’s and Other Large Economies’ Challenging and Interconnected Transitions," NBER Working Papers 21269, National Bureau of Economic Research, Inc.
    3. Daniel Harenberg & Alexander Ludwig, "undated". "Social Security and the Interactions Between Aggregate and Idiosyncratic Risk," Working Papers ETH-RC-14-002, ETH Zurich, Chair of Systems Design.
    4. Michael Reiter, 2015. "Solving OLG Models with Asset Choice," 2015 Meeting Papers 1509, Society for Economic Dynamics.
    5. Laurence Kotlikoff, 2013. "The US Fiscal Cliff – When Economists Recklessly Endanger the Economy," CESifo Forum, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, vol. 14(2), pages 03-08, August.
    6. Daniel Harenberg & Alexander Ludwig, 2015. "Social security in an analytically tractable overlapping generations model with aggregate and idiosyncratic risks," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 22(4), pages 579-603, August.
    7. Daniel Harenberg & Ludwig, Alexander, 2015. "Idiosyncratic Risk, Aggregate Risk, and the Welfare Effects of Social Security," MEA discussion paper series 201403, Munich Center for the Economics of Aging (MEA) at the Max Planck Institute for Social Law and Social Policy.
    8. Lilia Maliar & Serguei Maliar & John Taylor & Inna Tsener, 2015. "A Tractable Framework for Analyzing a Class of Nonstationary Markov Models," NBER Working Papers 21155, National Bureau of Economic Research, Inc.
    9. Serguei Maliar & John Taylor & Lilia Maliar, 2016. "The Impact of Alternative Transitions to Normalized Monetary Policy," 2016 Meeting Papers 794, Society for Economic Dynamics.
    10. Nick Draper & André Nibbelink & Johannes Uhde, 2013. "An Assessment of Alternatives for the Dutch First Pension Pillar, The Design of Pension Schemes," CPB Discussion Paper 259, CPB Netherlands Bureau for Economic Policy Analysis.
    11. Reiter, Michael, 2015. "Solving OLG Models with Many Cohorts, Asset Choice and Large Shocks," Economics Series 320, Institute for Advanced Studies.
    12. Nick Draper & André Nibbelink & Johannes Uhde, 2015. "An Assessment of Alternatives for the Dutch First Pension Pillar System," De Economist, Springer, vol. 163(3), pages 281-302, September.
    13. Seth G. Benzell & Eugene Goryunov & Maria Kazakova & Guillermo Lagarda & Kristina Nesterova & Laurence J. Kotlikoff, "undated". "Simulating Russia’s and Other Large Economies’ Challenging and Interconnected Transitions," Boston University - Department of Economics - The Institute for Economic Development Working Papers Series dp-274, Boston University - Department of Economics.

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    • E0 - Macroeconomics and Monetary Economics - - General

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