Aging and Deflation from a Fiscal Perspective Hideki Konishi and - PowerPoint PPT 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 KU (Waseda) -­‑4 ¡ -­‑2 ¡ 0 ¡ 2 ¡ 4 ¡ 6 ¡ 8 ¡ 1980 ¡ 1981 ¡ 1982 ¡ 1983 ¡ 1984 ¡ 1985 ¡ 1986 ¡ 1987 ¡ 1988 ¡ 1989 ¡ 1990 ¡ 1991 ¡ 1992 ¡ 1993 ¡ 1994 ¡ 1995 ¡ 1996 ¡ 1997 ¡ FTPL 1998 ¡ 1999 ¡ 2000 ¡ 2001 ¡ 2002 ¡ 2003 ¡ 2004 ¡ 2005 ¡ 2006 ¡ 2007 ¡ 2008 ¡ 2009 ¡ 2010 ¡ 2011 ¡ May 2014 @ Bundesbank 2012 ¡ 0 ¡ 5 ¡ 10 ¡ 15 ¡ 20 ¡ 25 ¡ Aging ¡ CPI ¡ 2 / 29

Negative Correlation bw Aging and Deflation in OECD Countries CPI inflation rate, average of 2000-13, % 20 Turkey Correlation ―0.53 (p-value 0.001) 15 (excluding Turkey: ― 0.51) 10 5 Mexico Mexico Germany 0 Switzerland Japan US -5 0 10 20 30 40 Old (+65) dependency ratio (20-64), average of 2000-12, % KU (Waseda) FTPL May 2014 @ Bundesbank 3 / 29

Motivation We examine how population aging influences fiscal balances and general prices within a political-economic framework. KU (Waseda) FTPL May 2014 @ Bundesbank 4 / 29

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 ◮ to make it possible to examine political and economic impacts of demographic changes. 2 We consider endogenous policy making ◮ by succession of short-lived governments, ◮ who choose tax rates and government bonds outstanding ◮ under the political influences of existing generations and strategic responses by future governments. KU (Waseda) FTPL May 2014 @ Bundesbank 5 / 29

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 Insufficient monetary policy, growth strategy, malfunctioning of 1 financial system, ... KU (Waseda) FTPL May 2014 @ Bundesbank 6 / 29

Four Features in Constructing a Model 1 Around 90% of the Japanese government bonds (JGBs) are held by domestic investors. Closed-economy model. 1 2 Nominal interest rate has been fixed at almost zero. Passive monetary policy is the key to FTPL. 1 3 A part of Japanese population aging is an unexpected phenomenon. KU (Waseda) FTPL May 2014 @ Bundesbank 7 / 29

Revisions in the Japanese Total Fertility Rate Forcast (Total Fer � lity Rate) 2.4 2.2 Forecast in 1976 Replacement ra � o 2 Forecast in 1986 Forecast in 1992 1.8 Forecast in 1997 1.6 Forecast in 2002 1.4 Forecast in 2012 1.2 Forecast in 2006 1 1965 1975 1985 1995 2005 2015 2025 2035 2045 2055 Year Source: Ministry of Health, Labour and Welfare; Na � onal Ins � tute of Popula � on and Social Security Research. KU (Waseda) FTPL May 2014 @ Bundesbank 8 / 29

Revisions in the Japanese Life Expectancy Forcast (Life Expectancy) 91 88 85 Female 82 Male 79 76 Actual Figure in 2012 Forecast in 1992 73 Forecast in 1997 Forecast in 2002 70 Forecast in 2006 Forecast in 2012 67 1965 1975 1985 1995 2005 2015 2025 2035 2045 2055 Year Source: Ministry of Health, Labour and Welfare; Na � onal Ins � tute of Popula � on and Social Security Research. KU (Waseda) FTPL May 2014 @ Bundesbank 9 / 29

Four Features in Constructing a Model 1 Around 90% of the Japanese government bonds (JGBs) are held by domestic 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. KU (Waseda) FTPL May 2014 @ Bundesbank 10 / 29

Voter Turnout Rates by Age in Japan 100 ¡ 90 ¡ 80 ¡ 20's ¡ 30's ¡ 70 ¡ 40's ¡ 50's ¡ 60 ¡ 60's ¡ 70's ¡ 50 ¡ 40 ¡ 30 ¡ 31 ¡ 32 ¡ 33 ¡ 34 ¡ 35 ¡ 36 ¡ 37 ¡ 38 ¡ 39 ¡ 40 ¡ 41 ¡ 42 ¡ 43 ¡ 44 ¡ 45 ¡ Note: The turnout rates by age in the Japanese lower house elections No.31–45 (from 1967 to 2009) are depicted. KU (Waseda) FTPL May 2014 @ Bundesbank 11 / 29

Model KU (Waseda) FTPL May 2014 @ Bundesbank 12 / 29

Fiscal Theory of Price Level (FTPL) Today’s price level P t is determined to balance govt’s intertemporal budget in real terms [ Leeper (’91), Woodford (’01) etc. ] . � − 1 � ∞ s RB t − 1 ∑ ∏ = T t − G t + ( T s − G s ) r k P t s = t + 1 k = t + 1 Assumptions of FTPL ◮ Nominal debts: govt has liabilities predetermined in nominal terms. ◮ Passive monetary policy: CB keeps a nominal interest rate constant over time. ◮ Active govt policy: govt is not constrained by its budget balance eqn. ◮ Price adjustment: Intertemporal budget is balanced only in equilibrium through current price adjustment. KU (Waseda) FTPL May 2014 @ Bundesbank 13 / 29

What does the Standard FTPL Predict? Price level in Japan should rise sooner or later. ◮ Fiscal surplus is expected to deteriorate due to aging. The standard FTPL takes account of no political factors. ◮ Policy choice will also respond to demographic aging through intergenerational politics. ◮ Need to incorporate intergenerational politics and endogenize policy choice into FTPL. KU (Waseda) FTPL May 2014 @ Bundesbank 14 / 29

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 survival probability θ j t . 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 tax rates to maximize the weighted average of the young’s and the old’s utility in each period, taking account of the effects on current and future prices as well as next govt’s policy responses. ◮ Solve the Markov-perfect equilibrium of the dynamic policy choice game. KU (Waseda) FTPL May 2014 @ Bundesbank 15 / 29

Household Each young household in period t chooses c y t and ℓ t to maximize the expected utility: � � u y ( c y θ j t + 1 u o ( c o t , ℓ t ) + β E t t + 1 ) , where � � t + 1 = r t + 1 ( 1 − τ t ) ℓ t − c y c o + g T t + 1 . t θ t + 1 KU (Waseda) FTPL May 2014 @ Bundesbank 16 / 29

Household 2 Indirect utility function of the young in period t is v y c y u y � t ( τ t ; � r t + 1 ) ≡ t ( τ t ; � r t + 1 ) , ℓ t ( τ t ; � r t + 1 ) � � r t + 1 a t ( τ t ; � r t + 1 ) � �� θ j t + 1 u o + g T + β E t , t + 1 θ t + 1 where a t represents saving per young and r t is the real interest rate given by RP t / P t + 1 . The indirect utility of the old in period t is � r t a t − 1 ( τ t − 1 ; � r t ) � v o t ( r t , a t − 1 ) ≡ u o + g T . t θ t KU (Waseda) FTPL May 2014 @ Bundesbank 17 / 29

Market Clearing for Government Bonds All the government bonds are held by domestic investors through insurance companies, ultimately by the young. a t ( τ t ; � r t + 1 ) = b t , where b t is the real government bond supply in t . KU (Waseda) FTPL May 2014 @ Bundesbank 18 / 29

Optimization Problem Facing Short-lived Governments Govt in period t chooses τ t , b t , and r t to maximize the weighted average of indirect utilities: t ( r t , b t − 1 ) + v y W t = γ t v o t ( τ t ; � r t + 1 ) , taking account of ◮ bonds market clearing condition: a t ( τ t ; � r t + 1 ) = b t . ◮ the budget balance: r t + 1 )) − ( n t + θ t ) g C t − θ t g T r t b t − 1 = n t ( b t + τ t ℓ t ( τ t ; � t . ◮ and the next-period government’s policy decision embodied in � r t + 1 . where n t ≡ N t / N t − 1 and θ j t represent young population’s growth rate and the survival probability. If γ t = θ t / n t , the government is a myopic utilitarian who maximizes the sum of utilities. KU (Waseda) FTPL May 2014 @ Bundesbank 19 / 29

Markov Perfect Equilibrium In a multi-period OLG model, extremely complex to calculate equilibrium, even its steady state. ◮ The entire path of past and future policies influence the behavior of current households and the current policy. ◮ ∂ a j t / ∂τ t ? However, simple in the 2-period OLG model. Eliminate r t and the optimization problem is reduced into � n t ( b t + τ t ℓ t ) − ( n t + θ t ) g C � τ t , b t W t = γ t u o t + g T + v y max t ( τ t | � r t + 1 ) t θ t subject to the bonds market clearing condition a t ( τ t ; � r t + 1 ) = b t . b t − 1 does not appear here! KU (Waseda) FTPL May 2014 @ Bundesbank 20 / 29

Result 1 b t − 1 does not appear here! The government’s optimal choices of τ t and b t should be independent of b t − 1 . ◮ Only the optimal choice of r t , or the price level P t , depends on b t − 1 . Burdens of public debt are not passed to future unborn generations even in the absence of altruistic bequests. [cf. Bowen, Davis, and Kopf (1960), Barro (1979)] ◮ Larger bond issues in period t end up with higher prices in period t and t + 1. ◮ Burdens of public debt are fully paid by current old though reductions in the real value of their assets and by young generation through reductions in the real interest rate. KU (Waseda) FTPL May 2014 @ Bundesbank 21 / 29