The Aging-Inflation Puzzle: on the Interplay between Aging, Inflation and Pension Systems

This paper focuses on the empirically observed relationship between demographic change and inflation and explores the theoretical nature of the puzzling link between the two. It puts the existent disparate empirical findings in the literature into perspective by formalizing an overlappinggenerations (OLG) model containing many of the underlying mechanisms that link demographic change and inflation dynamics. We are the first to formally disentangle the two components of demographic change: population size and structure, and determine how they separately affect inflation. We find that changes in population size are a main driver of inflationary pressures, but changes in population structure play a fundamental role in dampening or boosting inflationary dynamics since size effects are quite stable across the several scenarios tested. The main conclusions show a negative effect of demographic change/aging on inflation. We also conclude that the introduction of a public pay-as-you-go (PAYG) pension system has a negative impact on inflation, but these effects are dampened under general equilibrium conditions and when individuals can respond to changes in their income by adapting their labor supply. A simulation of different stages of demographic change and size of pension systems is carried out for a selected sample of individual countries. Findings suggest that aging countries with generous PAYG pension systems face strong deflationary pressures while countries that face aging but with higher fertility and immigration rates, such as the US, will experience the same deflationary pressures but much later in time. These results reinforce the hypotheses that we are entering a period of stagnation and they warn policy makers about the impact of demographic change on the foreseeable effects of monetary policy.