Slides 17

Foundations of Modern Macroeconomics: Chapter 17 1
Foundations of Modern Macroeconomics

B. J. Heijdra & F. van der Ploeg
Chapter 17: Intergenerational Economics,
II
Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Ben J. Heijdra
Aims of this lecture

• Study second “work-horse” model of overlapping generations based on discrete
time. Motivation for doing this:
– key model in modern macroeconomics and public finance theory
– better captures life-cycle behaviour
– chain of bequests easier to study
– natural extension to Computable General Equilibrium (CGE) policy models (e.g.

Auerbach & Kotlikoff)

Ben J. Heijdra
• Apply model to various issues:

– funded vs. unfunded pensions
– pension reform
– ageing and the macroeconomy
• Study various extensions

– growth and human capital
– public investment
– intergenerational accounting

Ben J. Heijdra
The Diamond-Samuelson model

Households
• live two periods: “youth” (superscript Y ) and “old age” (superscript O)
• consume in both periods
• work only during youth
• unlinked with past or future generations (no bequests)
• save during youth to finance old-age consumption (life-cycle saving)
• utility function of young agent at time t:
µ ¶
1
ΛYt ≡ U (CtY ) + O
U (Ct+1 )
1+ρ
– U (·) is felicity function (Inada-style conditions)
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– ρ > 0 captures time preference

• budget identities:
CtY + St = Wt
O
Ct+1 = (1 + rt+1 )St
– St is saving
– Wt is wage income (exogenous labour supply)
– rt+1 is real interest rate
• consolidated (lifetime) budget constraint:
O
Ct+1
Wt = CtY +
1 + rt+1

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• utility maximization yields consumption Euler equation:

U 0 (Ct+1
O
) 1+ρ
0 Y
=
U (Ct ) 1 + rt+1
• savings function:
St = S(Wt , rt+1 )
– 0 < SW < 1: both goods are normal
– Sr ambiguous (offsetting income and substitution effects)
– if intertemporal substitution elasticity is high (σ > 1) then Sr > 0 (and vice
versa)

Ben J. Heijdra
Firms
• perfect competition, CRTS technology Yt = F (Kt , Lt ), Inada conditions
• hire Lt from young (at wage Wt ) and Kt from old (at rental rate rt + δ ):
Wt = FL (Kt , Lt )
rt + δ = FK (Kt , Lt )
• interest rate facing young depends on future (aggregate) capital-labour ratio:

rt+1 + δ = FK (Kt+1 , Lt+1 )
• intensive-form expressions:
yt = f (kt )
Wt = f (kt ) − kt f 0 (kt )
rt+1 + δ = f 0 (kt+1 )
where yt ≡ Yt /Lt and kt ≡ Kt /Lt

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Aggregate market equilibrium

• resource constraint:
Yt + (1 − δ)Kt = Kt+1 + Ct , (A)
where Ct is aggregate consumption:
Ct ≡ Lt−1 CtO + Lt CtY
• consumption by the old:
Lt−1 CtO = (rt + δ)Kt + (1 − δ)Kt
• consumption by the young:
Lt CtY = Wt Lt − St Lt

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• Hence, aggregate output is:
Ct = (rt + δ)Kt + (1 − δ)Kt + Wt Lt − St Lt

= Yt + (1 − δ)Kt − St Lt (B)
• Comparing (A) and (B) yields:

St Lt = Kt+1
saving by the young determines the future capital stock
• Population growth:
Lt = L0 (1 + n)t , n > −1
• Intensive-form expression:
S (Wt , rt+1 ) = (1 + n) kt+1

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Dynamics and stability

• Model can be expressed in single nonlinear difference equation:
· ¸
(1 + n)kt+1 = S f (kt ) − kt f 0 (kt ), f 0 (kt+1 ) − δ
| {z } | {z }
Wt rt+1
• Slope of fundamental difference equation:

dkt+1 −SW kt f 00 (kt )
=
dkt 1 + n − Sr f 00 (kt+1 )
¯ ¯
¯ dk ¯
– stability condition is ¯ dkt+1 ¯ < 1
t
– numerator is positive (because 0 < SW < 1 and f 00 (·) < 0)

– denominator is ambiguous (because Sr is)

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• For expository purposes focus on unit-elastic case:
yt = kt1−²L so that Wt = ²L kt1−²L
U (x) = log x so that St = Wt /(2 + ρ)
• Fundamental difference equation for unit-elastic model:

µ ¶
²L
kt+1 = g(kt ) ≡ kt1−²L
(1 + n)(2 + ρ)
– Figure 17.1 shows the phase diagram
– Steady-state equilibrium is unique and stable

Ben J. Heijdra
kt+1=kt
kt+1
B
kt+1=g(kt)
A !
! E0
! !
45N
k0 k* kt
Figure 17.1: The Unit-Elastic Diamond-Samuelson Model

Ben J. Heijdra
Efficiency
• Ignoring transitional dynamics, what would an optimal steady-state look like?
• Optimal steady-state is such that the lifetime utility of a “representative” young agent
is maximized subject to the resource constraint:
µ ¶
Y Y 1
max Λ ≡ U (C ) + U (C O )
{C Y ,C O ,k} 1+ρ
O
C
subject to: f (k) − (n + δ)k = C Y +
1+n

Ben J. Heijdra
• The first-order conditions give rise to two types of golden rules:

– FONC #1, biological-interest-rate consumption golden-rule:
U 0 (C O ) 1+ρ
0 Y
=
U (C ) 1+n
– FONC #2, production golden-rule:
f 0 (k) = n + δ
– even if one is violated the other must still hold
• In decentralized setting, r = f 0 (k) − δ so production rule calls for r = n. If r < n

there is overaccumulation (dynamic inefficiency). This is quite possible in the
unit-elastic model.

Ben J. Heijdra
Applications of the model

• Old-age pensions
– fully-funded versus pay-as-you-go (PAYG) pensions
– reforming the pension system: transitional problems
• Ageing of the population

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Old-age pensions
• to study a pension system we must add government taxes and transfers to the model
CtY + St = Wt − Tt
O
Ct+1 = (1 + rt+1 )St + Zt+1
– Tt is tax levied on the young

– Zt is transfer provided to the old
• consolidated lifetime budget constraint:
O
Zt+1 Ct+1
W t − Tt + = CtY +
1 + rt+1 1 + rt+1

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• financing method of the government distinguishes two prototypical systems:

– Fully-funded system:
Zt+1 = (1 + rt+1 )Tt
Contribution Tt earns market interest rate (rt+1 )
– PAYG system:
Lt−1 Zt = Lt Tt ⇔ Zt = (1 + n)Tt
Contribution Tt earns the right to receive (1 + n)Tt+1 when old, where n is the
biological interest rate

Ben J. Heijdra
Fully-funded pensions
• striking neutrality property
• recall that lifetime budget constraint is:
O
Zt+1 Ct+1
W t − Tt + = CtY +
1 + rt+1 1 + rt+1
• recall that under fully-funded system we have:
Zt+1 = (1 + rt+1 )Tt
• so Tt and Zt+1 drop out of the lifetime budget constraint:

O
Ct+1
Wt = CtY +
1 + rt+1
• economies with or without fully-funded system are identical!
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• Intuition: household only worries about its total saving St + Tt = S (Wt , rt+1 ).
Part of this is carried out by the government but it carries the same rate of return.
• Proviso: system should not be “too severe” (Tt < S (Wt , rt+1 )). Otherwise
households are forced to save too much by the pension system.

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PAYG pensions
• features transfer from young to old in each period
• We look at defined-contribution system: Tt = T for all t so that Zt+1 = (1 + n)T
• household lifetime budget constraint becomes:
µ ¶ O
rt+1 − n Ct+1
Ŵt ≡ Wt − T = CtY +
1 + rt+1 1 + rt+1
• ceteris paribus factor prices, the PAYG system expands (contracts) the household’s
resources if the market interest rate, rt+1 , falls short of (exceeds) the biological
interest rate (n)

Ben J. Heijdra
• For logarithmic felicity the savings function becomes:

µ ¶ · µ ¶µ ¶¸
1 1+ρ rt+1 − n
S(Wt , rt+1 , T ) ≡ Wt − 1 − T
2+ρ 2+ρ 1 + rt+1
with 0 < SW < 1, Sr > 0, −1 < ST < 0 (if rt+1 > n), and ST < −1 (if
rt+1 < n).
• capital accumulation:
S(Wt , rt+1 , T ) = (1 + n) kt+1
• Factor rewards under Cobb-Douglas technology:
Wt ≡ W (kt ) = ²L kt1−²L
−²L
rt+1 ≡ r(kt+1 ) = (1 − ²L )kt+1 −δ

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• Fundamental difference equation is illustrated in Figure 17.2

– two equilibria: unstable on (at D) and stable one (at E0 )
– introduction of PAYG system is windfall gain to the then old but leads to crowding
out of capital (see path A to C to E0 ). In the long run, wages fall and the interest
rate rises.

Ben J. Heijdra
kt+1=kt
kt+1
B kt+1=g(kt,0)
!
A
! kt+1=g(kt,T)
!
E0
C!
D
!
! !
kMIN k0 k*(T) k* kt
Figure 17.2: PAYG Pensions in the Unit-Elastic Model

Ben J. Heijdra
Digression: welfare effect of PAYG system

• Ignoring transitional dynamics, what is the effect on welfare if T is changed
marginally?
• Two useful tools:

– Indirect utility function
– Factor price frontier
• Indirect utility function is defined as follows:

½ O
¾
Y Y Y O Y C
Λ̄ (W, r, T ) ≡ max Λ (C , C ) subject to Ŵ = C + ,
Y
{C ,C }O 1+r
with: µ ¶
r−n
Ŵ = W − T
1+r
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• Key properties of the IUF:

∂ Λ̄Y ∂ΛY
= Y
>0
∂W ∂C
µ ¶
∂ Λ̄Y S ∂ΛY
= Y
>0
∂r 1 + r ∂C
µ ¶
∂ Λ̄Y r − n ∂ΛY
= − Y
R0
∂T 1 + r ∂C
• An increase in T has three effects:

– wage effect: W ↓ which is bad for welfare
– interest rate effect: r ↑ which is good for welfare
– direct effect depending on sign of r −n

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• Factor price frontier is defined as follows:
Wt = φ(rt )
• Key property of FPF:

dWt
≡ φ0 (rt ) = −kt
drt

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• Welfare effect of marginal change in T :

dΛ̄Y ∂ Λ̄Y dW ∂ Λ̄Y dr ∂ Λ̄Y
= + +
dT ∂W · dT ∂r
µ dT ¶ ∂T µ ¶¸
Y
∂Λ dW S dr r−n
= Y
+ −
∂C dT 1 + r dT 1+r
µ ¶µ Y ¶· µ ¶¸
r−n ∂Λ dr
= − Y
1+k ∝ sgn(n − r)
1+r ∂C dT
• There is thus an intimate link between the welfare effect and dynamic (in)efficiency:
dΛ̄Y
– if r = n then dT
= 0 (no first-order welfare effects despite capital crowding out)
dΛ̄Y
– if economy is initially dynamically inefficient (r < n) then dT
> 0 (yield on
PAYG pension is higher than market interest rate and capital crowding out is a
good thing)

Ben J. Heijdra
From PAYG to funded system

• Ignoring transitional dynamics is not a good idea: there may be non-trivial welfare
costs due to transition from one to another equilibrium
• In a dynamically inefficient economy (with r < n initially) an increase in T moves

the economy in the direction of the golden-rule equilibrium and improves welfare for
all generations during transition. Optimal to expand and not to abolish the system.
• In a dynamically efficient economy (with r > n initially) an decrease in T moves the

economy in the direction of the golden-rule equilibrium but during transition it
improves welfare for some generations (e.g. those born in the steady-state) and
deteriorates it for other generations (e.g. the currently old). How do we evaluate the
desirability?
– postulate social welfare function, weighing all generations
– adopt the Pareto criterion
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• In a dynamically efficient economy it is impossible to move from a PAYG to a funded

system in a Pareto-improving manner: a cut in T makes the old worse off and there
is no way to compensate them without making some future generation worse off.

Ben J. Heijdra
PAYG pensions and induced retirement

• Martin Feldstein: PAYG system not only affects the household’s savings decision but
also its retirement decision
– Labour supply is endogenous during youth
– The pension contribution rate is potentially distorting (proportional to labour

income)
– Intragenerational fairness: pension is proportional to contribution during youth

(the lazy get less than the diligent)

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• Preview of some key results:

– pension contribution acts like an employment subsidy if the so-called Aaron
condition holds
– the general model displays a continuum of perfect foresight equilibria

(Cobb-Douglas case has unique perfect foresight equilibrium)
– if economy is in golden-rule equilibrium (r = n) then the contribution rate is

non-distorting at the margin
– Pareto-improving transition from PAYG to fully-funded system may now be

possible

Ben J. Heijdra
The D-S model with endogenous labour supply

Households
• Retired in old-age but endogenous labour supply during youth (early retirement)
• utility function of agent i:
ΛY,i
t ≡ ΛY
(Ct
Y,i
, C O,i
t+1 , 1 − N i
t)
CtY,i + Sti = Wt Nti − Tti

O,i
Ct+1 i
= (1 + rt+1 )Sti + Zt+1

Ben J. Heijdra
• pension contribution proportional to wage income:
Tti = tL Wt Nti
where tL is the statutory tax rate (0 < tL < 1)

• pension received during old age:
 
µ X j ¶ N i
Lt+1

i
Zt+1 = tL Wt+1 Nt+1  PLt t j
j=1 Nt
j=1
| {z } | {z }
(a) (b)
– Term (a): pension contributions of the future young generation (to be disbursed to
the then old)
– Term (b): share of pension revenue received by household i (intragenerational

fairness)
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• consolidated (lifetime) budget constraint:

O,i
¡ ¢ Y,i C t+1
1 − tE
L,t W N
t t
i
= C t +
1 + rt+1
" µ ¶ Ã PLt+1 j ! µ ¶#
Wt+1 j=1 Nt+1 1
tE
L,t ≡ tL 1 − PLt j
Wt j=1 tN 1 + rt+1
– agent has perfect foresight regarding labour supply of the future young
– effective tax rate, tE

L,t , different from the statutory tax rate, tL

Ben J. Heijdra
• Household chooses CtY,i , Ct+1

O,i
, and Nti in order to maximize lifetime utility subject
to the lifetime budget constraint. First-order conditions:
Y
µ ¶µ Y
¶
∂Λ 1 ∂Λ
O,i
=
∂Ct+1 1 + rt+1 ∂CtY,i
· Y
¸ Y
µ Y
¶
∂Λ ∂Λ E ∂Λ
− i
= i
= (1 − tL,t )Wt
∂Nt ∂(1 − Nt ) ∂CtY,i
– MRS between future and present consumption is equated to the relative price of
future consumption
– MRS between leisure and consumption (during youth) is equated to the

after-effective-tax wage rate
– it is not tL but tE
L,t which exerts a potentially distorting effect on labour supply

Ben J. Heijdra
• Symmetric solution as all agents are identical: Nti = Nt . With constant population
growth Lt+1 = (1 + n)Lt and tE L,t simplifies to:
· µ ¶µ ¶µ ¶¸
E Wt+1 Nt+1 1+n
tL,t ≡ tL 1 −
Wt Nt 1 + rt+1
• tE
L,t is negative if the Aaron condition holds, i.e. if the combined effect of growth in
wage income and in the population exceeds the interest rate:
µ ¶
∆Wt+1 Nt+1
tE
L,t <0 ⇔ 1+ (1 + n) > 1 + rt+1
W t Nt
– growth in wage income widens the revenue obtained per young household
– population growth increases the number of young households and thus widens
the total revenue

Ben J. Heijdra
• effect of tL on labour supply is ambiguous for two reasons:

– depends on Aaron condition (is tE
L,t negative of positive?)
– depends on income versus substitution effect
The macroeconomy
• Relation between household saving and the capital-labour ratio:
St = (1 + n)Nt+1 kt+1
where kt ≡ Kt / (Lt Nt ).
• Labour supply and the savings function:
¡ E
¢
Nt = N Wt (1 − tL,t ), rt+1
O
¡ E
¢
C Wt (1 − tL,t ), rt+1 − (1 + n)tL Wt+1 Nt+1
S [·] ≡
1 + rt+1
Ben J. Heijdra
• Fundamental difference equation:

£ E
¡ E
¢¤
S Wt (1 − tL,t ), rt+1 , tL Wt+1 N Wt+1 (1 − tL,t+1 ), rt+2
¡ E
¢
= (1 + n)N Wt+1 (1 − tL,t+1 ), rt+2 kt+1
– (bad) Wt = W (kt ) and rt = r(kt ) so expression contains kt , kt+1 , and kt+2

via the factor prices alone!
– (worse) tE L,t+1 depends on N t+2 which itself depends on k t+2 , k t+3 , and t E
L,t+2
(infinite regress)
– (disaster) FDE depends on the entire sequence of capital stocks {kt+τ }∞

τ =0 so
there is a continuum of perfect foresight equilibria
– (but) if the utility function is Cobb-Douglas, then labour supply is constant and the
perfect foresight equilibrium is unique (case discussed below)

Ben J. Heijdra
Steady-state welfare effect

• Despite non-uniqueness of transition path, the steady state equilibrium is unique, so
we can study its welfare properties
• The indirect utility function is now:

Λ̄Y (W, r, tL ) ≡ max ΛY (C Y , C O , 1 − N )
{C Y ,C O ,N }
· µ ¶¸
r−n Y CO
subject to: W N 1 − tL =C +
1+r 1+r
• The welfare effect of a marginal change in the statutory tax is:
µ ¶µ ¶· µ ¶¸
dΛY r−n ∂ΛY dr
= −N Y
W + (1 − tL )k
dtL 1+r ∂C dtL
– no first-order welfare effect if r = n (golden-rule equilibrium)
dr
– if r 6= n then welfare effect is ambiguous because dtL
is ambiguous

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Cobb-Douglas preferences
• Assume that the utility function is now:
µ ¶
1
ΛYt ≡ log CtY + λC log[1 − Nt ] + log CtO
1+ρ
where λC ≥ 0 regulates the strength of the labour supply effect.
• Optimal household decision rules:
µ ¶
1+ρ
CtY = WtN
2 + ρ + λC (1 + ρ)
µ ¶
O 1 + rt+1
Ct+1 = WtN
2 + ρ + λC (1 + ρ)
2+ρ
Nt =
2 + ρ + λC (1 + ρ)

Ben J. Heijdra
with:
· µ µ ¶µ ¶¶¸
Wt+1 1+n
WtN ≡ Wt (1 − tE
L,t ) ≡ Wt 1 − tL 1 −
Wt 1 + rt+1
– labour supply is constant (IE and SE offset each other)
– consumption during youth depends on the future interest rate via the effective tax
rate
• Fundamental difference equation is now:

µ ¶µ ¶
W (kt )(1 − tL ) 1+ρ tL (1 + n) W (kt+1 )
(1 + n)kt+1 = −
2+ρ 2+ρ 1 + r(kt+1 )
– first-order difference equation in the capital-labour ratio so the transition path is
determinate
– assuming stability, there is a unique perfect foresight equilibrium adjustment path
– an increase in tL leads to crowding out of the steady-state capital stock (just as when
lump-sum taxes are used)
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• Unlike the lump-sum case, the increase in tL causes a distortion in the labour supply
decision (provided r 6= n)
– recall that the deadweight loss of the distorting tax hinges on the elasticity of the
compensated labour supply curve (which is positive) not of the uncompensated
labour supply curve (which is zero for CD preferences).
– (weak) implication for pension reform: provided lump-sum contributions can be

used during transition, a gradual move from PAYG to a funded system is possible

Ben J. Heijdra
Digression on deadweight loss of taxation

• Deadweight loss of a distorting tax: the loss in welfare due to the use of a distorting
rather than a non-distorting tax.
• In the context of our model, the DWL of the pension tax tL can be illustrated with
Figure 17.3
• Assumptions: (W, r) held constant and r > n (dynamic efficiency)

• Model solved in two steps to develop diagrammatic approach
• We define lifetime income as:
· µ ¶¸
r−n
X ≡ W N 1 − tL ≡ W N (1 − tE
L)
1+r

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X
TE
EE
IC
E0
! ! E0
E2
!
E1
! ! E1
!B
A
!
!
-N 0 CO
Figure 17.3: Deadweight Loss of Taxation

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• Stage 1: household chooses C Y and C O to maximize:

µ ¶
Y 1
log C + log C O ,
1+ρ
subject to the constraint:
O
C
CY + =X
1+r
This yields:
µ ¶ µ ¶
Y 1+ρ O 1+r
C = X, C = X
2+ρ 2+ρ
The second expression is plotted in the right-hand panel of Figure 17.3.
• By substituting the solutions for C Y and C O into the utility function we find:
µ ¶
Y 2+ρ
Λ ≡ log X + λC log[1 − Nt ] + constant
1+ρ

Ben J. Heijdra
• Stage 2: the household chooses X and N to maximize ΛY subject to the constraint

X = W N (1 − tE L ). The resulting expressions are:
2+ρ
N =
2 + ρ + λC (1 + ρ)
(2 + ρ) W (1 − tE
L)
X =
2 + ρ + λC (1 + ρ)
The maximization problem is shown in the left-hand panel of Figure 17.3: IC is the
indifference curve and TE is the constraint. Both are downward sloping because
−N is measured on the horizontal axis!

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• The optimal solution for tE

L = 0 is given by point E0 in both panels. Now consider
what happens if tE
L is increased:
– right-hand panel: no effect on EE curve (r is constant)
– left-hand panel: TE rotates counterclockwise. New equilibrium at E1 (directly below E0 )
– decomposition of total effect: SE: move from E0 to E2 ; IE move from E2 to E1
• On the vertical axis:

– 0B is the income one would have to give the household to restore it to its initial
indifference curve IC (hypothetical transfer Z0 )
– AB represents the tax revenue collected from the agent (i.e. tE

LWN)
– 0B minus AB is the dead-weight loss of the tax.
• If lump-sum tax were used then the slope of TE would not change and the DWL
would be zero (hypothetical transfer equal to tax revenue).

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Macroeconomic effects of ageing

• The old-age dependency ratio is the number of retired people divided by the
working-age population
• In the models studied so far, the old-age dependency ratio is assumed to be

L 1
constant: Lt−1 = 1+n .
t
• As the data in Table 17.1 show, this is rather unrealistic:

– in the OECD and the US the population is ageing: proportion of young falls whilst
proportion of old rises
– NOTE: demographic predictions are notoriously unreliable!!!

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Table 17.1. Age composition of the population

1950 1990 2025
World
0-19 44.1 41.7 32.8
20-65 50.8 52.1 57.5
65+ 5.1 6.2 9.7
OECD
0-19 35.0 27.2 24.8
20-64 56.7 59.9 56.6
65+ 8.3 12.8 18.6
United States
0-19 33.9 28.9 26.8
20-65 57.9 58.9 56.0
65+ 8.1 12.2 17.2

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• In the absence of immigration, there are two causes for ageing:

– decrease in fertility
– decrease in mortality
• We can study the first effect with D-S model: focus on interaction with pension
system
Revised model
• Population:
Lt = (1 + nt ) Lt−1
with nt variable

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• Saving-capital link:
S(Wt , rt+1 , nt+1 , T ) = (1 + nt+1 )kt+1
– Sn < 0: as nt+1 decreases, the future pension decreases

(Zt+1 = (1 + nt+1 ) T ), and saving increases.
– LHS: a reduction in nt+1 allows for a higher capital-labour ratio for a given level of
saving
• A permanent decrease in the fertility rate increases the long-run capital stock. The
transition path is shown in Figure 17.4. Economy-wide asset ownership rises
because the proportion of old increases.
• Qualitatively the same conclusion as Auerbach & Kotlikoff reach on basis of detailed
CGE model!

Ben J. Heijdra
kt+1=kt
kt+1
E1
! kt+1=g(kt,n1)
B kt+1=g(kt,n0)
!
!
E0
A
!
k0 k(n0) k(n1) kt
Figure 17.4: The Effects of Ageing

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Extensions
• Human capital accumulation
– automatic knowledge transfer and endogenous growth
– a family externality and the benefit of a mandatory education system
• Public investment
– macroeconomic effects
– some modified golden rules
• Intergenerational accounting

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Human capital accumulation

• Human capital creation may be an important engine of growth in the economy
• We study an OLG version of the Lucas-Uzawa model (also studied in Chapter 14)
proposed by Azariadis-Drazen
Households
• work full time during second period of life
• divide time between training and working during first period
• lifetime utility:
ΛY,i
t ≡ ΛY
(Ct
Y,i
, C O,i
t+1 )
– no direct utility attached to leisure and to training (knowledge not value per se)

Ben J. Heijdra
CtY,i + Sti = Wt Hti Nti

O,i
Ct+1 = (1 + rt+1 )Sti + Wt+1 Ht+1
i
– Wt is the wage rate per efficiency unit of labour

– Hti is the level of human capital of worker i at time t
– Nti is the amount of time spent working (rather than training) during youth
– CtY,i , Ct+1
O,i
, and Sti have their usual meaning
• time constraint during youth:
Eti = 1 − Nti ≥ 0
– time endowment is unity
– Eti is time spent on training during youth

Ben J. Heijdra
• Training technology:
i
Ht+1 = G(Eti )Hti
– positive but non-increasing returns to training (G0 > 0 ≥ G00 )
– no knowledge depreciation (G(0) = 1)
• Household optimization in two steps:
– choose training level to maximize lifetime income
– choose consumption and savings (subject to lifetime income)

Ben J. Heijdra
Step 1: Training decision

• Household chooses Eti such that lifetime income is maximized:
· i
¸
i i i i Wt+1 G(Et )
It (Et ) ≡ Ht Wt (1 − Et ) +
1 + rt+1
• first-order (Kuhn-Tucker) condition:
i
· 0 i
¸
dIt i Wt+1 G (Et )
i
= Ht −Wt + ≤ 0,
dEt 1 + rt+1
µ i¶
i i dIt
Et ≥ 0, Et i
=0
dEt

Ben J. Heijdra
• Two possible solutions:

– no-training solution:
0 Wt (1 + rt+1 )
G (0) < ⇒ Eti = 0
Wt+1
Corner solution because training technology not productive enough!
– training solution:
µ ¶
Wt+1
Eti >0 ⇒ 1 + rt+1 = G0 (Eti )
Wt
Invest in human capital until its yield equals the yield on financial assets.

Ben J. Heijdra
Step 2: Consumption-saving decisions

• Household chooses CtY,i , Ct+1
O,i
and Sti in order to maximize lifetime utility subject to
the lifetime budget constraint:
O,i
C
CtY,i + t+1
= Iti ,
1 + rt+1
where Iti is now maximized lifetime income (see Step 1).
• Key expression is the savings function:

³ ´
i
Sti = S rt+1 , (1 − Eti )Wt Hti , Wt+1 Ht+1

Ben J. Heijdra
Further elements of the model

• Initial condition for household i:
Hti = Ht
Household “inherits” average level of human capital in the economy (osmotic human
capital transfer across generations)
• Model is symmetric so index i can be dropped

• Constant population (Lt = Lt−1 = 1)
• Total labour supply in efficiency units is Nt = (1 − Et )Ht + Ht

Ben J. Heijdra
Summary of the model
Nt+1 kt+1 = S(rt+1 , (1 − Et )Wt Ht , Wt+1 Ht+1 ) (a)
rt+1 + δ = f 0 (kt+1 ) (b)
Wt = f (kt ) − kt f 0 (kt ) (c)
Nt = (2 − Et )Ht (d)
µ ¶
Wt+1
1 + rt+1 = G0 (Et ) (e)
Wt
Ht+1 = G(Et )Ht (f)

Ben J. Heijdra
• Model displays endogenous growth in the steady state. This is illustrated in Figure
1−²
17.5 for the unit-elastic case with technology yt = kt L and utility
ΛYt = log CtY + (1/(1 + ρ)) log Ct+1 O
.
– PB is portfolio balance line: (k, E) combinations for which yields on physical and human
capital equalize
– SI is the savings-investment line: (k, E) combinations for which savings equals

investment
– equilibrium at E0
– growth rate is γ ≡ G(E) − 1 is depicted in bottom panel

i
• Engine of growth in the model is the training technology Ht+1 = G(Eti )Hti
– level of training explains growth rate in human capital
– knowledge/technical skills are disembodied (live on after agent has died)
– endogenous growth vanishes if knowledge/technical skills are embodied

Ben J. Heijdra
PB
E0
!
SI
E
(
(=G(E)-1
!
E0
Figure 17.5: Endogenous Growth due to Human Capital Formation

Ben J. Heijdra
Application of the A-D model

• Eckstein-Zilcha: why do we have compulsory education systems?
• Key idea: parents may under-invest in the human capital of their children (intra-family
external effect)
• We discuss a simple version of the E-Z model to demonstrate underinvestment result

• Utility function:
ΛYt ≡ ΛY (CtY , Ct+1
O
, Zt , Ot+1 )
– CtY is consumption when young
O
– Ct+1 is consumption when old
– Zt is leisure during youth
– Ot+1 ≡ (1 + n)Ht+1 is total human capital of the agent’s offspring (Ht+1 is
human capital per child, 1 + n is the number of children)
Ben J. Heijdra
• In-house training technology (no schools)
Ht+1 = G(Et )Htβ
– Et is educational effort per child

– G(·) is the training curve (satisfying 0 < G(0) ≤ 1, G(1) > 1, G0 > 0 ≥ G00 )
– positive but diminishing marginal product of human capital: 0 < β ≤ 1.
– NOTE difference with A-D model: now parent chooses human capital of children
(costs and benefits accrue to different agents)

Ben J. Heijdra
• Time endowment: households has two units of time available:

– one unit is supplied inelastically to the labour market
– one is divided over leisure and training: Zt + (1 + n)Et = 1

• Household’s lifetime budget constraint:
O
Ct+1
CtY + = Wt H t
1 + rt+1
– Wt = FN (Kt , Nt ) where Nt ≡ Lt Ht (efficiency units of labour)
– rt + δ = FK (Kt , Nt )

Ben J. Heijdra
• Household chooses CtY , Ct+1

O
, Zt , Et , and Ht+1 to maximize lifetime utility subject
to (a) the training technology, (b) the time constraint, and (c) the consolidated budget
constraint. Key first-order conditions:
∂ΛY /∂CtY
Y O
= 1 + rt+1
∂Λ /∂Ct+1
∂ΛY 0 ∂ΛY
G (Et )Htβ − < 0 =⇒ Et = 0
∂Ot ∂Zt
∂ΛY 0 ∂ΛY
G (Et )Htβ − = 0 ⇐= Et > 0 (A)
∂Ot ∂Zt
– corner solution if the net marginal benefit of training is negative
– for interior solution training provided until net marginal benefit of training is zero
(all gains exhausted)

Ben J. Heijdra
• Assume that interior solution (A) obtains. Note that (A) only contains costs and
benefits of the parent! First hint at underinvestment problem. Not all benefits are
taken into account.
• Formal analysis of underinvestment problem: Social Welfare Function approach

• The Social Welfare Function is:
∞
X ∞
X
SW 0 ≡ λt ΛYt = λt ΛY (CtY , Ct+1
O
, Zt , Ot+1 )
t=0 t=0
– SW 0 is social welfare in the planning period (t = 0)

– {λt }∞
t=0 is a positive monotonically decreasing sequence of weights attached to
P∞
the different generations (which satisfies t=0 λt < ∞)

Ben J. Heijdra
• resource constraint:
O
C
CtY + t + (1 + n)kt+1 = F (kt , Ht ) + (1 − δ)kt
1+n
where kt ≡ Kt /Lt
• social planner chooses sequences for consumption ({CtY }∞ t=0 and {C O
}∞
t+1 t=0 ), the
stocks of human and physical capital ({Kt+1 }∞ t=0 and {H t+1 } ∞
t=0 ), and the
educational effort ({Et }∞
t=0 ) in order to maximize SW 0 subject to (a) the training
technology, (b) the time constraint, and (c) the resource constraint.

Ben J. Heijdra
• Most interesting (for our purposes) first-order condition:

·µ ¶
∂ΛY (x̂ t) ∂ΛY (x̂ t)
= G 0
(Êt )Ĥtβ
∂Zt ∂Ot
Ã !
∂ΛY (x̂t )
+ O
FN (k̂t+1 , Ĥt+1 )
∂Ct+1
Ã !Ã !#
β(1 + n)Ĥt+2 ∂ΛY (x̂t ) ∂ΛY (x̂t+1 )/∂Zt+1
+ 1+β O Y
G0 (Êt+1 )Ĥt+1 ∂Ct+1 ∂ΛY (x̂t+1 )/∂Ct+1
– marginal social costs (LHS) must be equated to marginal social benefits (RHS)
– marginal social benefits consist of three terms:

∗ “own” term, affecting decision maker directly (line 1)
∗ “induced” term, affecting earning power of children (line 2)
∗ “induced” term, affecting incentive of children to educate their children provide
(line 3)
Ben J. Heijdra
• Second and third effects are ignored by parents which leads to under-investment in
human capital. Policy options:
– complex set of incentives (taxes/subsidies) to correct the parent’s behaviour
– compulsory education

Ben J. Heijdra
Public investment
• Empirical work by Aschauer prompts a number of questions:
– What are the macroeconomic effects of public investment?
– How much public capital should a country possess?
• Study these questions with a modified D-S model

– exogenous labour supply / lump-sum taxes
– public capital is a stock variable
– public capital affects factor productivity (e.g. bridges, roads, airports, etc.)

Ben J. Heijdra
• Accumulation identity:
Gt+1 − Gt = ItG − δ G Gt
– Gt+1 is public capital stock
– ItG is public investment
– δ G is depreciation rate on public capital
• Technology:
Yt = F (Kt , Lt , gt )
where gt ≡ Gt /Lt
– CRTS in (Kt , Lt )
– positive but diminishing marginal product of public capital, Fg > 0, Fgg < 0

Ben J. Heijdra
• Competitive production yields rental expressions:
rt = r(kt , gt ) ≡ fk (kt , gt ) − δ,
Wt = W (kt , gt ) ≡ f (kt , gt ) − kt fk (kt , gt ),
where f (kt , gt )
≡ F (Kt /Lt , 1, gt ) is the intensive-form production function. By
1−² ² η
assumption, gt affects rt and Wt positively (Example: Yt = Kt L Lt L gt with
0 < η < ²L )
• Household utility: µ ¶
1
ΛYt = log CtY + O
log Ct+1
1+ρ
• Household lifetime budget constraint:
O O
T t+1 Ct+1
Ŵt ≡ Wt − TtY − = CtY +
1 + rt+1 1 + rt+1
Ben J. Heijdra
• Savings function:
µ ¶
¡ Y
¢ O
Tt+1
St = (1 − c) Wt − Tt +c
1 + rt+1
1+ρ
where c ≡ 2+ρ

Ben J. Heijdra
Model summary
• Model is:
(1 + n)gt+1 = iG
t + (1 − δ G )gt (a)
TtO
iG
t = TtY
+ (b)
1+n
£ ¤ O
cTt+1
Y
(1 + n)kt+1 = (1 − c) W (kt , gt ) − Tt + (c)
1 + r(kt+1 , gt+1 )
– (a): accumulation identity for public capital per worker (iG

t ≡ ItG /Lt )
– (b): government budget constraint
– (c): link between savings and private capital formation
• Immediately obvious that financing method critically affects the model: who pays for
iG
t affects (c) and thus the private capital stock and the rest of the economy

Ben J. Heijdra
• In Figure 17.6 we consider the case in which the old are untaxed (TtO = 0 for all t)
– GE line: (g, k) combinations for which gt+1 = gt .
∗ horizontal
∗ gt rises (falls) for points above (below) the GE line–see the vertical arrows.
– KE line: (g, k) combinations for which kt+1 = kt .
∗ slope is negative (positive) for low (high) private capital stock [Intuition: slope
determined by 1 + n − (1 − c) Wk ; Wk high (low) if k is low (high)]
∗ kt increases (decreases) for points above (below) the KE line–see the
horizontal arrows.
– two steady-state equilibria:

∗ E0 : stable node (stable monotonic or cyclical adjustment)
∗ A: saddle point (unstable because both gt and kt are predetermined variables)

Ben J. Heijdra
• Focus on equilibrium E0 : what happens if iG

t is increased?
– both GE and KE shift up
– effect on g unambiguously positive
– effect on k depends on relative scarcity of public capital (W ↑ but TtY ↑ so net

effect ambiguous): k rises (falls) if iG /y < η²L (> η²L ), i.e. if public capital is
initially relatively scarce (abundant).

Ben J. Heijdra
gt
KE: kt+1=kt
A E0
g ! ! GE: gt+1=gt
SP
A
!
0
kA k* k kt
Figure 17.6: Public and Private Capital

Ben J. Heijdra
How much public capital should we have?

• SWF approach in an OLG setting
• Social Welfare Function:
µ ¶−1 ∞ µ
X ¶t
1+n Y Y O 1+n
SW 0 ≡ Λ (C−1 , C0 ) + ΛY (CtY , Ct+1
O
)
1 + ρG 1 + ρG
t=0
– Benthamite format (“...greatest happiness of the greatest number...”)
– ρG is the planner’s discount rate (ρG > n). May or may not equal ρ.
– special treatment of current old generation to avoid dynamic inconsistency of the
social optimum (see Intermezzo)
• Resource constraint:
CtO
CtY + + (1 + n) [kt+1 + gt+1 ] = f (kt , gt ) + (1 − δ)kt + (1 − δ G )gt
1+n
Ben J. Heijdra
• Social planner chooses {CtY }∞

t=0 , {C O ∞
}
t t=0 ), {gt+1 } ∞
t=0 , and {k t+1 } ∞
t=0 ), in order
to maximize SW 0 subject to the resource constraint, taking k0 and g0 as given.
• Key first-order conditions for the social optimum:

∂ΛY (x̂t )/∂CtY
O
= 1 + r̂t+1 (a)
∂ΛY (x̂t )/∂Ct+1
r̂t+1 = fk (k̂t+1 , ĝt+1 ) − δ = fg (k̂t+1 , ĝt+1 ) − δ G (b)
∂ΛY (x̂t )/∂CtY
= 1 + ρG (c)
∂ΛY (x̂t−1 )/∂CtO
– (a): socially optimal Euler equation; MRS between present and future
consumption equated to gross interest factor
– (b): yields on private and public capital should be equalized (efficient investment)

Ben J. Heijdra
– (c): ρG determines optimal intratemporal division of consumption. With additively

separable preferences we get:
U 0 (ĈtY )1 + ρG
=
0 O
U (Ĉt ) 1+ρ
∗ if ρG > ρ then planner ensures that U 0 (ĈtY ) > U 0 (ĈtO ) i.e. that ĈtY < ĈtO
(favour the old).
∗ if ρG = ρ then planner ensures that U 0 (ĈtY ) = U 0 (ĈtO ) i.e. that ĈtY = ĈtO
(egalitarian solution)
∗ if ρG < ρ then planner ensures that U 0 (ĈtY ) < U 0 (ĈtO ) i.e. that ĈtY > ĈtO
(favour the young).

Ben J. Heijdra
Some final remarks:

• In the steady state, r̂t = ρG so (b) simplifies to:
[r̂ ≡] fk (k, g) − δ = ρG = fg (k, g) − δ G
Hence, modified golden rules for private and public capital accumulation feature the
social planner’s discount rate
• First-best social optimum can be decentralized if and only if the right policy
instruments are available:
– iG (and thus g ) is set correctly
– age-specific lump-sum taxes are available (even stronger requirement than in the
representative-agent model)
• If one or more of the policy variables is not available, the problem becomes a
second-best optimization problem (Ramsey taxation, modified Samuelson rule)
Ben J. Heijdra
Intergenerational accounting
• How should we measure the government’s fiscal stance?
• Government budget deficit is fundamentally ambiguous
– how do we treat public investment
– how to treat future commitments (medicare, social security, etc.)
– how to treat government assets
• Auerbach, Gokhale, and Kotlikoff:

– “...every dollar the government takes in or pays out is labeled in a manner that is
economically arbitrary”
– propose method of generational accounting
– concepts of “deficit” and “intergenerational distribution” are twin sisters

Ben J. Heijdra
• Stated advantages of method:

– invariant to accounting labels
– bring out zero-sum aspect of GBC (some generation has to pay)
– allows evaluation of effects of different policies
• We use a simplified D-S model to illustrate (and criticize) the method

– constant population (Lt−1 = Lt = 1)
– public goods for young and old (e.g. swimming pools and old-age homes)

Ben J. Heijdra
Government
• Flow budget identity
Bt+1 = (1 + rt )Bt + GO
t + GY
t − T t
O
− T t
Y
– Bt is government debt
– GO
t is pure public good provided to old (free of charge)
– GYt is pure public good provided to young (free of charge)

– TtO lump-sum tax levied on old
– TtY lump-sum tax levied on young

Ben J. Heijdra
• The government budget restriction (implied by the solvency condition) is:

∞
X £ O Y
¡ ¢¤
Bt = Rt−1,τ Tt+τ + Tt+τ − GO
t+τ + GYt+τ
τ =0
where Rt−1,τ is a discount factor:

τ µ
Y ¶
1
Rt−1,τ =
s=0
1 + rt+s
– pre-existing debt must eventually be covered in present-value terms by future

primary surpluses
– solvency requirement: debt growth dominated by discounting effect

Ben J. Heijdra
Households
• Standard assumptions
• Key expressions:
CtY + St = Wt − TtY
Y O
Ct+1 = (1 + rt+1 )St − Tt+1
St = Bt+1 + Kt+1

Ben J. Heijdra
• Lifetime budget constraint:

O
Ct+1
CtY + = Wt − Tt,t
1 + rt+1
– Tt,t is the present value of (lump-sum) taxes that a generation born in period t
(second subscript) must pay over the course of its life seen from the perspective
of period t (first subscript):
O
T t+1
Tt,t ≡ TtY + .
1 + rt+1

Ben J. Heijdra
Generational accounts
• The GBC can be rewritten in terms of tax bills paid by present and future generations
(see book for details):
µ ¶ µ ¶· O ¸
1 1 Tt+1
Bt = TtO + TtY +
1 + rt 1 + rt 1 + rt+1
| {z } | {z }
(a) (b)
µ ¶µ ¶· O ¸
1 1 Y Tt+2
+ Tt+1 +
1 + rt 1 + rt+1 1 + rt+2
| {z }
(c)
µ ¶µ ¶µ ¶· O ¸
1 1 1 Y Tt+3
+ Tt+2 + + ....
1 + rt 1 + rt+1 1 + rt+2 1 + rt+3
∞
X £ O Y
¤
− Rt−1,τ Gt+τ + Gt+τ
τ =0

Ben J. Heijdra
– (a): remaining tax to be paid by old at time t
– (b): lifetime tax bill of young at time t
– (c): lifetime tax bill of young at time t + 1
– NOTE: all expressed in present value terms (discounted back to the end of period
t − 1)
• A more compact statement of the generational accounts is:
∞
X ∞
X
£ ¤
Bt + Rt−1,τ GO
t+τ + GY
t+τ = Tt−1,k ,
τ =0 k=t−1
where the Tt−1,k terms are defined as follows:

Ben J. Heijdra
µ ¶
1
Tt−1,t−1 ≡ TtO (existing old)
1 + rt
µ ¶
1
Tt−1,t ≡ Tt,t (existing young)
1 + rt
µ ¶" O
#
1 Y Tt+1
= Tt +
1 + rt 1 + rt+1
Tt−1,k ≡ Rt−1,k−1 Tk,k (future generations)
" #
O
Tk+1
= Rt−1,k−t TkY +
1 + rk+1

Ben J. Heijdra
• Auerbach, Kotlikoff and various co-workers have constructed empirical

implementations of the generational accounting methods. In Table 17.2 we show the
male generational accounts (for the US, in 1991). Key features:
– Row “0”: newborns in 1991: net payment to the government of almost US

$79,000 in (PV terms)
– Row “40”: 40-year old males in 1991: net payment is US $180,000!
– Row “70”: 70-year old males in 1991: net transfer of US $81,000!
– Row “Future”: the typical future newborn male must pay US $166,500 (compared
to US $79,000 for a newborn male in 1991)
– A-K: there is a striking generational imbalance in US fiscal policy.

Ben J. Heijdra
Table 17.2. Male generational accounts

Generation’s Net Tax Transfer
age in 1991 payments payments receipts
×$1000 ×$1000 ×$1000
0 78.9 99.3 20.4
10 125.0 155.3 30.3
20 187.1 229.6 42.5
30 205.5 258.5 53.0
40 180.1 250.0 69.9
50 97.2 193.8 96.6
60 -23.0 112.1 135.1
70 -80.7 56.3 137.0
80 -61.1 30.2 91.3
90 -3.5 8.8 12.3
Future 166.5

Ben J. Heijdra
Discussion
• Restate some of the key points suggested by Buiter
• True, deficit is meaningless indicator
• Method of Generational Accounting also has its own problems:
– lives or dies with validity of the life-cycle model (Ricardian equivalence invalid)
– method says nothing about effects of public goods
– method ignores general equilibrium effects
• In principle one could build a CGE model to take all these effects into account.
Practice, however, will prove recalcitrant.

Ben J. Heijdra
Punchlines
• Studied workhorse model of macroeconomics and public finance
– life-cycle saving
– dynamic inefficiency quite possible
– wide set of applications
• Pensions
– fully funded: neutral (saving by the government)
– PAYG: not neutral (welfare and crowding-out effects)
– transitional problems
– population ageing may lead to extra saving under PAYG system

Ben J. Heijdra
• Human capital
– osmotic transfer and growth
– mandatory education
• Public capital
– macroeconomic effects
– some more golden rules
• The pros and cons of generational accounting

Ben J. Heijdra

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Foundations of Modern Macroeconomics: Chapter 17 1

Foundations of Modern Macroeconomics

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Aims of this lecture

– key model in modern macroeconomics and public finance theory

– better captures life-cycle behaviour

– chain of bequests easier to study

– natural extension to Computable General Equilibrium (CGE) policy models (e.g.

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

• Apply model to various issues:

– ageing and the macroeconomy

• Study various extensions

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

The Diamond-Samuelson model

– ρ > 0 captures time preference

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

• utility maximization yields consumption Euler equation:

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

• interest rate facing young depends on future (aggregate) capital-labour ratio:

where yt ≡ Yt /Lt and kt ≡ Kt /Lt

Aggregate market equilibrium

where Ct is aggregate consumption:

Ct ≡ Lt−1 CtO + Lt CtY

• consumption by the old:

Lt−1 CtO = (rt + δ)Kt + (1 − δ)Kt

• consumption by the young:

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

• Hence, aggregate output is:

Ct = (rt + δ)Kt + (1 − δ)Kt + Wt Lt − St Lt

• Comparing (A) and (B) yields:

S (Wt , rt+1 ) = (1 + n) kt+1

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Dynamics and stability

• Slope of fundamental difference equation:

– numerator is positive (because 0 < SW < 1 and f 00 (·) < 0)

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

• For expository purposes focus on unit-elastic case:

yt = kt1−²L so that Wt = ²L kt1−²L

U (x) = log x so that St = Wt /(2 + ρ)

• Fundamental difference equation for unit-elastic model:

– Steady-state equilibrium is unique and stable

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Figure 17.1: The Unit-Elastic Diamond-Samuelson Model

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

• The first-order conditions give rise to two types of golden rules:

– even if one is violated the other must still hold

• In decentralized setting, r = f 0 (k) − δ so production rule calls for r = n. If r < n

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Applications of the model

– reforming the pension system: transitional problems

• Ageing of the population

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

– Tt is tax levied on the young

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

• financing method of the government distinguishes two prototypical systems:

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Zt+1 = (1 + rt+1 )Tt

• so Tt and Zt+1 drop out of the lifetime budget constraint:

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

Foundations of Modern Macroeconomics – Chapter 17 Version 1.0 – March 2004

• For logarithmic felicity the savings function becomes:

S(Wt , rt+1 , T ) = (1 + n) kt+1

• Factor rewards under Cobb-Douglas technology: