Generational Risk -- Is It a Big Deal? Simulating an 80-Period OLG Model with Aggregate Shocks

Abstract

The theoretical literature presumes generational risk is large enough to merit study and that such risk can be meaningfully shared via appropriate government policies. This paper assesses these propositions. It develops a computational technique to overcome the curse of dimensionality and measure generational risk in an 80-period OLG model. The model features isoelastic preferences, moderate risk aversion, Cobb-Douglas technology, and shocks to both TFP and capital depreciation.

When shocks are calibrated using empirically plausible parameter values (our baseline model), the model reproduces the U.S. variability of output and wages. But it overstates the variability of the economy's overall return to aggregate wealth. Even so, the model understates the economy's risk premium (the mean return on aggregate wealth less the mean return on safe assets). But, as shown by Constantinides, Donaldson, and Mehra (2002) and Hasanhodzic (2014), adding hard or increasing borrowing costs can readily reduce equilibrium risk-free rates to essentially any desired level with little or no impact on the economy's key macro variables. Based on this calibration, we find that generational risk is small and that Social Security can exacerbate it.

When depreciation shocks are accentuated to reproduce the observed variability of equity returns, as in Krueger and Kubler (2006), the model's risk premium is close to the equity premium observed in the stock market. Yet, with this calibration, the model greatly overstates the variability of output and wages. It also produces substantial generational risk -- risk that Social Security can materially reduce.

Under both calibrations, we find that even a one-period bond market is very effective, indeed far more effective than Social Security, in sharing risks among contemporaneous generations. We also find that policy-induced intergenerational redistribution can produce far larger generational risk than macroeconomic fluctuations.

Keywords: Intergenerational Risk Sharing, Government Transfer Policies, Aggregate Shocks, Incomplete Markets, Stochastic Simulation

JEL Classification: E21, E24, E62, H55, H31, D91, D58, C63, C68