1 The Global Macroeconomic Consequences of a Demographic Transition Warwick J McKibbin Centre for...

The Global Macroeconomic Consequences of a Demographic

Transition

Warwick J McKibbin

Centre for Applied Macroeconomic Analysis, RSPAS, ANU;Lowy Institute for International Policy, Sydney

The Brookings Institution, Washington DC;

Prepared for a seminar at the Harvard Program on the Global Demography of Aging. Cambridge Mass Thursday, February 23

Overview

• Summary of Global Demographic trends

• Macroeconomic issues

• Alternative approaches

• Consequence of global demographic change in 10 regions from 2004 to 2050

• Conclusions

Figure 1: Population Growth Rate 1950-2050

Europe

Latin America

Source: UN, World Population Prospects: The 2004 Revision (Medium Variant)

Figure 2: Elderly Dependency Ratio 1950-2050(ratio of adults 65+ to adults 15-65)

Europe

Latin America

Figure 3: Child Dependency Ratio 1950-2050(ratio of children 0-14 to adults 15-65)

Europe

Latin America

Main Macroeconomic Impacts

• Aggregate saving, consumption, wealth– Composition of consumption bundles

• Investment rates• aggregate• across sectors

• Labor markets• Government budgets• => General equilibrium impacts on trade and financial

flows and asset prices including real exchange rates

Macroeconomic Impacts• What happens to the current account on any

country depends on the impact on savings relative to investment

– A rise in savings relative to investment will tend to improve the current account

– A fall in savings larger than a fall in investment will tend to worsen the current account

Alternative Approaches

• Cross sectional/time series econometric estimation of aggregate saving and investment and growth equations or current accounts

• Higgins (1998), Masson et al (1998), Helliwell (2004), IMF (2004)

• Tend to find negative impact of dependency rates on investment, savings and the current account

• Vector Autoregression models with demographic and economic variables (Kim and Lee (2005)

• Strong negative impact of dependency rates on saving• Strong negative impact of dependency rates on current

account

• Calibrated OLG models of single economies and multiple economies– Brooks (2005), Ingenue (2004)

• Calibrated CGE models of global economy– Tyers (2005) using GTAP

• Calibrated/estimated DIGE/DSGE models

Bryant/Faraque/Laxton

McKibbin/Nguyen/Callen/Battini

Theoretical Approach

• Follows Yaari/Blanchard/Weil models as extended by Faruqee, Laxton, Bryant, McKibbin and others

• Demographics from the “bottom up”– Approximate an OLG model using a probability of

death and exogenous profiles of birth and death rates to generate cohort adjustment over time

– The demographic change is taken as exogenous and cohort aggregation effects are calculated outside the core model

Minimum Requirements

• Adults are distinguished from children so we can capture the importance of changes in the youth dependency ratio

• Country specific models for the major countries/regions so we can capture the asymmetries

Children

• Are born to adults and stay children for 16 years• Do not supply labour• Do not hold financial wealth• Receive transfers from adults (which grow at the rate of

economy wide productivity growth) which they consume• Have a different birth rate (defined as the number of

children as a percent of the adult population) than the adult maturity rate (defined as the number of new adults as a percent of the adult population)

• Have a different mortality rate than adults

Adults/workers

• Emerge at age 17 from the pool of children• The adult maturity rate is the rate of emergence of adults

as a percent of the total adult population• Are born with the productivity of the cohort alive in time t

and then acquire productivity based on the estimate age earnings profiles over time.

• Die at a constant rate over time (major shortcoming but needed for aggregation).

Introduce empirical age earnings profiles

• Labor income – rises with age and experience– reaches a peak in late middle age– then declines gradually for the rest of life

• The shape of the age-earnings profile for individuals in the economy is assumed to be the same for all individuals and unchanged through time.

• But the demographic composition of the population can change over time.

• Because aggregate labor income is obtained by aggregating over individuals that differ in age and experience, moreover, the bottom-up aggregation over individuals permits the demographic changes to influence both the aggregate level and the age distribution of labor income.

• The hump-shaped profile of earnings by age influences both the supply side and the demand side of the model economy's behavior.

• Hence through these life-cycle effects, changes in demographics significantly influence macroeconomic outcomes.

Supply side effects

• On the supply side, the earnings profile is an indicator of the changes in a cohort's relative productivity and its supply of labor over its lifetime.

• The marginal product of capital will change and investment will respond

Demand Side

• On the demand side, the anticipated path of labor income determines the saving plans of consumers over their lifetimes.

• Changes in investment will change the demand the goods.

MSG-Cubed Model: Countries

• Japan• USA• Western Europe• Rest of OECD• Eastern Europe and the Former Soviet Union• China• India• Other Asia• Latin America• Other Developing Countries

MSG-Cubed Model: Sectors

• Energy• Non-Energy

• Capital Producing sector

MSG-Cubed model

• Estimated dynamic intertemporal model with Keynesian short-run rigidities– Adjustment costs in capital accumulation– Financial capital mobile given risk premia– Wages adjust slowly given labour market rigidities– Financial markets for equity, bonds, money– Mix of optimizing and rule of thumb decision rules

Question

• We want to estimate the overall impacts of demographic change on the global economy from 2005 onwards

Approach

• Develop a baseline projection of the global economy from 1985 to 2100 with a full demographic transition where countries are adjusting towards a common steady state with the same birth and death rates but from very different initial conditions

Calculating the Impact of Demographic Change

• Solve the model again from 1985 to 2100 setting the birth rates of children at the steady state rates– The initial conditions in 1985 will already have the

expectations of a demographic transition in the initial asset stocks.

– Allow some time for the asset adjustment to occur– then examine the difference between the results with

and without the demographic transition from 2005.

Figure 5: Removing the Demographics(A stylized Representation)

1985 1994 2003 2012 2021 2030 2039 2048 2057 2066 2075 2084

Developing countries

Industrial countries

No Demographics

projection with demographic

Figure 6: Change in Child Birth Rate (relative to steady state)

Europe

Latin America

Japan Europe

Latin America

Figure 7: Change in Adult Maturity Rate (relative to steady state)

Europe

Latin America

JapanEurope

Latin America

US GDP Growth(relative to no demographic transi tion)

global ow n

Japan GDP Growth(relative to no demographic transi tion)

global ow n

Latin America GDP Growth(relative to no demographic transi tion)

global ow n

China GDP Growth(relative to no demographic transi tion)

-0.6-0.4-0.2

00.20.40.60.8

global ow n

Figure 8: Contribution to GDP growth of Own versus Global Demographic Change

Figure 10: Contribution to Total Savings of Own versus Global Demographic

Change US Total Savings/GDP

(relative to no demographic transi tion)

-4-3-2-101234

global ow n

Japan Total Savings/GDP(relative to no demographic transi tion)

global ow n

China Total Savings/GDP (relative to no demographic transi tion)

global ow n

Latin America Total Savings/GDP(relative to no demographic transi tion)

global ow n

Figure 11: Contribution to Private Investment of Own versus Global Demographic

Change

US Investment/GDP (relative to no demographic transi tion)

-3-2-1012345

global ow n

Japan Investment/GDP (relative to no demographic transi tion)

global ow n

Latin America Investment/GDP (relative to no demographic transi tion)

global ow n

China Investment/GDP (relative to no demographic transi tion)

global ow n

Figure 12: Contribution to Current Accounts of Own versus Global Demographic

Change US Current Account/GDP

(relative to no demographic transi tion)

global ow n

Japan Current Account/GDP(relative to no demographic transi tion)

global ow n

China Current Account/GDP(relative to no demographic transi tion)

00.10.2

0.30.40.50.6

0.70.8

global ow n

Latin America Current Account/GDP(relative to no demographic transi tion)

global ow n

Figure 13 : Contribution to Long Term Real Interest Rates of Own versus Global Demographic Change

US Real 10 Year Bond Rate(relative to no demographic transi tion)

global ow n

Japan Real 10 Year Bond Rate(relative to no demographic transi tion)

global ow n

China Real 10 Year Bond Rate(relative to no demographic transi tion)

global ow n

Latin America Real 10 Year Bond Rate(relative to no demographic transi tion)

global ow n

Implications

• Several adjustment mechanisms possible– Reallocate inputs within economies– Raise productivity growth to generate more resources

to deal with macroeconomic adjustments• In an open economy

– Allow labor to flow across borders from labour abundant into labour scarce countries

– Allow goods which embody labour to flow from labour abundant countries into labour scarce countries

– Allow capital to flow from labour scarce countries to labour abundant countries

Policy Implications to be explored Further

• Open economies to international trade so that more labour can be imported into labour scarce countries embodied in goods

• Deregulate protected sectors such as the service sector in economies such as Japan to raise productivity growth and free up scarce labour

• Allowing greater capital mobility (and better allocation of capital) so that capital can flow to labour rather than labour flow to capital.

Policy Implications

• Batini, Callen and McKibbin (2005) find that raising productivity growth and reducing the risk of investing in developing countries can swamp the macroeconomic impacts of demographic change

Conclusions

• Demographic change projected over the next century has a significant impact on aggregate economic variables within countries as well as economic outcomes between countries

• It is not sufficient to examine demographic change in a country without some allowance for what is happening in the world as a whole

Background Websites

www.sensiblepolicy.com

www.gcubed.com

1 The Global Macroeconomic Consequences of a Demographic Transition Warwick J McKibbin Centre for...

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