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On the Consequences of Demographic Change for Rates of Returns to Capital, and the Distribution of Wealth and Welfare

Author

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  • Ludwig, Alexander

    (Mannheim Research Institute for the Economics of Aging (MEA) and Sonderforschungsbereich 504)

  • Krüger, Dirk

    (University of Pennsylvania)

Abstract

In the industrialized world the population is aging over time, reducing the fraction of the population in working age. Consequently labor is expected to be scarce, relative to capital, with an ensuing decline in the real return on capital. This paper uses demographic projections together with a large scale multi-country Overlapping Generations Model with uninsurable idiosyncratic uncertainty to quantify the distributional and welfare consequences of these changes in factor prices induced by the demographic transition. In our model capital can freely flow between different regions in the OECD (the U.S., the EU and the rest of the OECD). Thus international capital flows may in principle mitigate the decline in rates of returns one would expect in the U.S. if it were a closed economy. We find exactly the opposite. In the U.S. as an open economy, rates of return are predicted to decline by 86 basis points between 2005 and 2080. If the U.S. were a closed economy, this decline would amount to only 78 basis points. This result is due to the fact that other regions in the OECD will age even more rapidly; therefore the U.S. is “importing” the more severe aging problem from these regions, especially Europe. A similar conclusion is reached if we let capital flow freely between the OECD and the rest of the world (ROW). While ROW currently has a younger population structure, it is predicted to age even more severely in the next decades, giving rise to an even more pronounced decline in world rates of return to capital. In order to evaluate the welfare consequences of the demographic transition we ask the following hypothetical question: suppose a household economically born in 2005 would live through the economic transition with changing factor prices induced by the demographic change (but keeping her own survival probabilities constant at their 2005 values), how would its welfare have changed, relative to a situation without a demographic transition? We find that households experience significant welfare losses due to the demographic transition, in the order of 2 −5% of consumption, depending on their initial productivity level and the design of the pension system. These losses are mainly due to the fact that lower future returns to capital make it harder for households to save for retirement. On the other hand, if the OECD suddenly opens up to ROW in 2005 and ROW has higher returns to capital before the world capital market integration, then these losses are reduced to 1.5 − 2.5%.

Suggested Citation

  • Ludwig, Alexander & Krüger, Dirk, 2006. "On the Consequences of Demographic Change for Rates of Returns to Capital, and the Distribution of Wealth and Welfare," Sonderforschungsbereich 504 Publications 07-11, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
  • Handle: RePEc:xrs:sfbmaa:07-11
    Note: Financial support from the Deutsche Forschungsgemeinschaft, SFB 504, at the University of Mannheim, is gratefully acknowledged.
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • C68 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computable General Equilibrium Models
    • D33 - Microeconomics - - Distribution - - - Factor Income Distribution
    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications
    • E25 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Aggregate Factor Income Distribution

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