Aging and Deflation from a Fiscal Perspective - Presentation

Aging and Deflation from a Fiscal Perspective

Hideki Konishi and Kozo Ueda

Waseda Univ

May 2014 @ Bundesbank

KU (Waseda) FTPL May 2014 @ Bundesbank 1 / 29

Negative Correlation bw Aging and Deflation in Japan

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5

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25

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-‐2

0

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4

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8

1980

19

81

1982

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83

1984

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85

1986

19

87

1988

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89

1990

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91

1992

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93

1994

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95

1996

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97

1998

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99

2000

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01

2002

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03

2004

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05

2006

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07

2008

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09

2010

20

11

2012

CPI

Aging


Negative Correlation bw Aging and Deflation in OECDCountries

5

10

15

20

CPI inflation rate, average of 2000-13, %

Correlation ―0.53 (p-value 0.001)(excluding Turkey: ―0.51)

Turkey

Mexico

-5

0

0 10 20 30 40

Old (+65) dependency ratio (20-64), average of 2000-12, %

Japan

Mexico

SwitzerlandUS

Germany


Motivation

We examine how population aging influences fiscal balances andgeneral prices within a political-economic framework.


What We Do

We extend the standard fiscal theory of the price level (FTPL).

1 We embed the FTPL into a standard overlapping generation (OLG)model

I to make it possible to examine political and economic impacts ofdemographic changes.

2 We consider endogenous policy making

I by succession of short-lived governments,I who choose tax rates and government bonds outstandingI under the political influences of existing generations and strategic

responses by future governments.


What We Do NOT Do

1 Challenge FTPL

2 Endogenize interactions between monetary policy and fiscal policy

3 Do realistic quantitative analysis

4 Investigate other reasons of persistent deflation

1 Insufficient monetary policy, growth strategy, malfunctioning offinancial system, ...


Four Features in Constructing a Model

1 Around 90% of the Japanese government bonds (JGBs) are held bydomestic investors.

1 Closed-economy model.

2 Nominal interest rate has been fixed at almost zero.

1 Passive monetary policy is the key to FTPL.

3 A part of Japanese population aging is an unexpected phenomenon.


Revisions in the Japanese Total Fertility Rate Forcast

1

1.2

1.4

1.6

1.8

2

2.2

2.4

1965 1975 1985 1995 2005 2015 2025 2035 2045 2055Source: Ministry of Health, Labour and Welfare; Na!onal Ins!tute of Popula!on and Social Security Research.

(Total Fer!lity Rate)

Year

Replacement ra!oForecast in 1976

Forecast in 1986

Forecast in 1992

Forecast in 2012

Forecast in 1997

Forecast in 2002

Forecast in 2006


Revisions in the Japanese Life Expectancy Forcast

67

70

73

76

79

82

85

88

91

1965 1975 1985 1995 2005 2015 2025 2035 2045 2055

Actual Figure in 2012Forecast in 1992Forecast in 1997Forecast in 2002Forecast in 2006Forecast in 2012

Source: Ministry of Health, Labour and Welfare; Na!onal Ins!tute of Popula!on and Social Security Research.

(Life Expectancy)

Year

Female

Male


Four Features in Constructing a Model

1 Around 90% of the Japanese government bonds (JGBs) are held bydomestic investors.

2 Nominal interest rate has been fixed at almost zero.

3 A part of Japanese population aging is an unexpected phenomenon.

4 The voter turnout rates for the young generation especially 20’s, 30’s,and 40’s are declining and the gap between generations is widening.


Voter Turnout Rates by Age in Japan

30

40

50

60

70

80

90

100

31 32 33 34 35 36 37 38 39 40 41 42 43 44 45

20's

30's

40's

50's

60's

70's

Note: The turnout rates by age in the Japanese lower house elections No.31–45 (from

1967 to 2009) are depicted.


Model


Fiscal Theory of Price Level (FTPL)

Today’s price level Pt is determined to balance govt’s intertemporalbudget in real terms [Leeper (’91), Woodford (’01) etc.] .

RBt−1Pt

= Tt − Gt +∞

∑s=t+1

(s

∏k=t+1

rk

)−1(Ts − Gs)

Assumptions of FTPL

I Nominal debts: govt has liabilities predetermined in nominal terms.I Passive monetary policy: CB keeps a nominal interest rate constant

over time.I Active govt policy: govt is not constrained by its budget balance eqn.I Price adjustment: Intertemporal budget is balanced only in equilibrium

through current price adjustment.


What does the Standard FTPL Predict?

Price level in Japan should rise sooner or later.

I Fiscal surplus is expected to deteriorate due to aging.

The standard FTPL takes account of no political factors.

I Policy choice will also respond to demographic aging throughintergenerational politics.

I Need to incorporate intergenerational politics and endogenize policychoice into FTPL.


Model Features

OLG model consists of the young and the old.

Labor income tax only. No physical capital.

Each individual will live for two period with an uncertain survivalprobability θjt .

Monetary policy is passive, keeping a fixed nominal interest rate.

Govt remains in power only for one period.

A succession of short-lived govts choose debt issues and income taxrates to maximize the weighted average of the young’s and the old’sutility in each period, taking account of the effects on current andfuture prices as well as next govt’s policy responses.

I Solve the Markov-perfect equilibrium of the dynamic policy choicegame.


Household

Each young household in period t chooses cyt and `t to maximize the

expected utility:

uy (cyt , `t) + βEt

[θjt+1uo(co

t+1)

],

where

cot+1 =

rt+1

θt+1

[(1− τt)`t − cy

t

]+ gT

t+1.


Household 2

Indirect utility function of the young in period t is

v yt (τt ;~rt+1) ≡ uy

(cyt (τt ;~rt+1), `t(τt ;~rt+1)

)+βEt

[θjt+1uo

(rt+1at(τt ;~rt+1)

θt+1+ gT

t+1

)],

where at represents saving per young and rt is the real interest rategiven by RPt/Pt+1.

The indirect utility of the old in period t is

vot (rt , at−1) ≡ uo

(rtat−1(τt−1 ;~rt)

θt+ gT

t

).


Market Clearing for Government Bonds

All the government bonds are held by domestic investors throughinsurance companies, ultimately by the young.

at(τt ;~rt+1) = bt ,

where bt is the real government bond supply in t.


Optimization Problem Facing Short-lived Governments

Govt in period t chooses τt , bt , and rt to maximize the weightedaverage of indirect utilities:

Wt = γtvot (rt , bt−1) + v y

t (τt ;~rt+1),

taking account of

I bonds market clearing condition: at(τt ;~rt+1) = bt .I the budget balance:

rtbt−1 = nt (bt + τt`t(τt ;~rt+1))− (nt + θt)gCt − θtgT

t .I and the next-period government’s policy decision embodied in~rt+1.

where nt ≡ Nt/Nt−1 and θjt represent young population’s growth rateand the survival probability. If γt = θt/nt , the government is amyopic utilitarian who maximizes the sum of utilities.


Markov Perfect Equilibrium

In a multi-period OLG model, extremely complex to calculateequilibrium, even its steady state.

I The entire path of past and future policies influence the behavior ofcurrent households and the current policy.

I ∂ajt/∂τt?

However, simple in the 2-period OLG model.

Eliminate rt and the optimization problem is reduced into

maxτt ,bt

Wt = γtuo

(nt(bt + τt`t)− (nt + θt)gC

t

θt+ gT

t

)+ v y

t (τt |~rt+1)

subject to the bonds market clearing condition at(τt ;~rt+1) = bt .

bt−1 does not appear here!


Result 1

bt−1 does not appear here!

The government’s optimal choices of τt and bt should be independentof bt−1.

I Only the optimal choice of rt , or the price level Pt , depends on bt−1.

Burdens of public debt are not passed to future unborn generationseven in the absence of altruistic bequests. [cf. Bowen, Davis, andKopf (1960), Barro (1979)]

I Larger bond issues in period t end up with higher prices in period t andt + 1.

I Burdens of public debt are fully paid by current old though reductionsin the real value of their assets and by young generation throughreductions in the real interest rate.


Result 2

Prices respond to aging in opposite directions, depending on whetherit is caused by longer lifetime or by lower birth rate.

Suppose that γt = θt/nt , population ratio. Then,

I Lower birth rate nt inflates prices as the standard FTPL predicts.I Longer life-expectancy θt is likely to inflate prices as lower birth rate

does, if it is expected.I Longer life-expectancy θt is likely to deflate prices as lower birth rate

does, if it is unexpected.


Intuition

Economic impact of aging

I Fiscal surplus declines due to a decline in tax revenues from the young,raising tax and price.

Political impact of aging

I Govt opts to decrease deficits, increase taxes, and lower price.

Moreover, unexpectedly long lifetime makes the old worse-offbecause their savings turn out insufficient.

I This strengthens the government’s distributional concerns, leading todeflation.


Concluding Remarks

Negative correlation

I A mild deflation and population aging in Japan’s lost decades.

Our result here suggests that this puzzling observation might becaused by

I the combined political and economic effects of unexpected populationaging having occurred from extension in longevity.

Future work

I address the accumulation in government bonds outstanding that isobserved in Japan

I introduce an endogenous monetary policy responseI introduce foreign investors to buy the government bondsI make a quantitative analysis


Appendix: quantitative analysis


Responses of Prices to Extension of Longevity

The perfect foresight case experiences inflation whereas theunexpected case experiences deflation, implying that the publicexpectation for aging is a key to understanding the response of theprice levels.

0.98

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Expected shock

Unxpected shock


Calibration

2 period OLG

I 1 period is 40 years.I Utility is given by

u(c lt , `lt) =

(c lt

)1−σ

1− σ− χ

(`lt

)1+1/υ

1 + 1/υ,

where σ = 1 and υ = 0.5.I β = 0.9940 (1% annually), gT

t = 0.01, and gCt = 0.01.

I Variables associated with demography, θt and nt , are derived fromJapan’s official statistics and forecasts by National Institute ofPopulation and Social Security Research (IPSS).

F As an innitial state, in 1997, θt = 0.620, nt = 0.304, andγyt /γo

t = 0.828.F As a final state, according to long-run forecasts in 2060 made in 2012,

θt = 0.781, nt = 0.555, and γyt /γo

t = 0.856.


Transition Path

Deflation due to recovered birth rate

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Tax rate

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Real interest rate (annualized)

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Real bond


Transition Path under Exogenous Tax Rate

Multi-peiod OLG (16 generations, 5-year interval)

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Real government bond

Transition period

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Real interest rate (annual)

Transition period

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Inflation rate (annual)

Transition period

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Income tax rate

Transition period


Aging and Deflation from a Fiscal Perspective - Presentation

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