EC004-OLG Model PPT - Part 3

Output Dynamics with Heterogenous Agents:
Impact of Income/Wealth Inequality in Solow, R-C-K and OLG
Mausumi Das
Lecture 14, EC004, DSE
April 12, 2024
Das (Lecture 14, EC004, DSE) Heterogenous Agents: Solow to R-C-K to OLG April 12, 2024 1 / 26
Dynamic E¢ ciency in the OLG Model:
In the last lecture we saw that the OLG model, despite having a
neoclassical production function (identical to Solow/R-C-K model)
and optimisiting savings behaviour by agents, generates results which
are diametrically opposite of Solow/R-C-K:
(1) We need additional restrictions on the utility function to guarantee that
there exits a unique dynamic path under perfect foresight;
(2) Even after imposing these restrictions, it is not guaranteed that a
non-trivial steady state will exits/will be unique/will be stable.
What about dynamic e¢ ciency?
I provided a counter example to show that even dynamic e¢ eciency is
no longer guranteed in the OLG model.
Dynamic Ine¢ ciency in the OLG Model: Example with
Speci…c Functional Form
Let
1 2
U (ct,t , ct,t +1 ) log ct1 + β log ct2+1 ;
f (kt ) = (kt )α ; 0 < α < 1.
Also let the rate of depreciation be 100%, i.e., δ = 1.
Thus the life-time budget constraint of the representative agent of
generation t is given by:
2
ct,t
1 +1
ct,t + = wt
rt +1
The corresponding FOC:
2
ct,t +1
1
= βrt +1 (1)
ct,t
OLG Model: Speci…c Functional Forms (Contd.)
From the FONC and the life-time budget constraint, we can derive
the optimal solutions as:
1 1
ct,t = wt ;
1+β
β
st = wt ;
1+β
2 1
ct,t +1 = βrt +1 wt
1+β
Does this savings function satisfy the su¢ ciency condition for
existence of a unique perfect foresignt path?
Since sr = 0 here, the given utility function does satisfy the su¢ ciency
condition for existence of a unique perfect foresight path.
Indeed, for log utility, the substitution and income e¤ect of a price
change are exactly equal; so they nullify each other.
OLG Model: Dynamics with Speci…c Functional Forms
Having established that a unique perfect foresight path exists for the
economy, let us now characterise the exact dynamics of the
capital-labour ratio (kt ).
The dynamics of kt is captured by the following equation:
st 1 β
kt +1 = = wt
(1 + n ) 1+n 1+β
Given the production function,
wt = (1 α) (kt )α
Thus the dynamics of this speci…c case is simple:
1 β
kt +1 = (1 α) (kt )α
1+n 1+β
It is easy to see that the above phase line is increasing and concave;
hence it will generate a unique non-trivial steady state which is
globally stable.
OLG Model: Dynamic Ine¢ ciency
The corresponding (non-trivial) steady state solution is given by:
1 β
k = (1 α ) (k ) α
1+n 1+β
1
1 α β 1 α
i.e., k =
1+n 1+β
Is this steady state dynamically e¢ cient? Not necessarily!
Notice that given the speci…c functional form, the ‘golden rule’value
of the capital-labour ratio can be derived as:
kg : f 0 (k ) = (n + δ )
1
i.e., kg : α (k ) α = 1+n
1
α 1 α
i.e., kg =
1+n
OLG Model: Dynamic Ine¢ ciency (Contd.)
It is easy to verify that the steady state under this speci…c example
will be dynamically ine¢ cient (i.e., k > kg ) whenever
β α
>
1+β 1 α
1 1
Example: β = ;α = .
2 5
Reason for Dynamic Ine¢ ciency: OLG vs R-C-K
Thus we see that dynamic ine¢ ciency may arise in the OLG model - despite
optimizing savings behaviour by households. This apparently paradoxical
result stems from the fact that agents are ‘sel…sh’in the OLG model; they
do not care for their children’s utility/consumption.
Thus when they choose their optimal consumption and savings today (which
is equivalent to choosing between consumption today and tomorrow), they
equate the MRS with (the discounted value of) the actual future return:
u 0 (ct,t
1 )
2
= β(rt +1 + 1 δ)
u 0 (ct,t +1 )
2
ct,t u 0 (ct,t
1 )
1
i.e., 1
+1
' 2
T 1 according as (rt +1 + 1 δ) R .
ct,t u 0 (ct,t +1 ) β
This implies that consumption tomorrow would rise, fall or remain
unchanged if the corresponding gross return (rt +1 + 1 δ) is greater,
equal to or less than the subjective cost 1β .
Dynamic Ine¢ ciency: OLG vs R-C-K (Contd.)
In contrast, recall that in the R-C-K model with population growth,

the corresponding (Euler) equation was given by:
(rt +1 + 1 δ)
u 0 cth = βu 0 cth+1
(1 + n )
cth+1 u 0 cth (rt +1 + 1 δ) 1
i.e., ' T 1 according as R
cth 0 h
u ct + 1 (1 + n ) β
Hence in the R-C-K framework, consumption tomorrow would rise,

fall or remain unchanged if the population-adjusted gross return,
[rt +1 + (1 δ)]
measured by is greater, equal to or less than the
1+n
subjective cost 1β .
Note that both in the OLG model and the R-C-K model, households
will stop saving whenever their percieved return is less than the
1
subjective cost .
β
But due to presence of intergenerational altruism, in the R-C-K model
the return is adjusted for population growth: the household knows
that tomorrow that same total return will have to be shared with
(1 + n) extra members. Hence for them the relevant ‘per member’
[rt +1 + (1 δ)]
return is given by .
1+n
In an OLG model, the sel…sh agent does not have share his returns
with anybody else in the hosuehold. Hence for him the relevant return
is just [rt +1 + (1 δ)] .
Now let us consider a situation where the (net) return to capital in

the economy is lower the population growth rate, i.e,
[ 1 + rt + 1 δ)] < 1 + n
This implies that the marginal product of capital is such that

f 0 (kt +1 ) rt +1 < n + δ.
In other words, this is a scenario where the economy is in a

dynamically ine¢ cient region.
Can an economy remain stuck in such a dynamically ine¢ cient

region? It can - if households continue to save despite the net return
to capital falling below the population growth rate.
Note that in the R-C-K model households will necessarily stop saving
when the (net) return to capital has fallen below the population
growth rate.
[r + (1 δ)]
Why? Because if [rt +1 + (1 δ)] < 1 + n, then t +1 < 1,
1+n
1
while β > 1.
Thus, at that point the cost outweighs the bene…t for the altruistic
households in R-C-K model.
But there is no reason why households in the OLG model would stop
saving in such scenario!
Why? Because even if [rt +1 + (1 δ)] < 1 + n, it might still greater
than the subjective cost 1β .
Indeed, to the extent 1β < [rt +1 + (1 δ)] < 1 + n, the OLG
households will continue to save.
Thus there is a tendency to oversave in the OLG model
(compared to the R-C-K model), due to which the economy
may get stuck in a dynamically ine¢ cient region.
OLG vs R-C-K Model: Role of Population Growth
Our discussion above suggests that this tendency to oversave in the
OLG model is connected to a positive population growth.
Note that a positive population growth poses a trade-o¤ for any
household (and indeed for any economy): you have more hands to
work, but also more mouths to feed.
Altruistic parents in the R-C-K model account for both sides of this
trade-o¤.
Sel…sh parents in the OLG model ex-post bene…t from the fact that
there are more hands to work (which means higher labour supply and
therefore, in ceteris paribus, lower capital-labour ratio, which raises
the interest income enjoyed by the parental generation). But ex ante
they would not feel obliged to change their savings behaviour in order
to feed more mouths of the younger generation.
Indeed, in the OLG model positive population growth creates a
positive externality from the young generation to the old
generation.
Dynamic Ine¢ ciency & Scope for Government Intervention
in the OLG Model:
Since under the OLG framework, the steady state of the decentralized
market economy may be dynamically ine¢ cient, this justi…es a role of
government in improving e¢ ciency.
What kind of government policies can bring an economy back from a
dynamically ine¢ cient steady state to the golden rule level?
We now turn to a discussion of some possible policies and the e¢ cacy.
Dynamic Ine¢ ciency & Scope for Government Intervention
in the OLG Model:
We have seen that dynamic ine¢ ciency may arise in the OLG model
because agents have a tendency to oversave.
Why do agents oversave? Because they want to leave su¢ cient
resources for old age consumption.
Thus one way to curb the oversaving could be to provide for old age
consumption through a pension/social security scheme.
Notice that any pension scheme necessarily entails a redistribution of
resources between young and old: government takes away a part of
the wage income of the young/working population and makes
resources available for consumption to the old/retired population.
Since young agents would earn less, presumably they will also save
less.
Thus the problem of oversaving could be attenuated.
OLG Model: Pensions and Social Securities
An important policy debate in this context revolves around how the

government should design the pension system.
There are two alternatives:
A fully funded pension scheme, in which the current young
generation are asked to make mandatory contributions to the social
security system, and their contributions are paid back to them in their
old age.
A pay-as-you-go social security system, in which the governemnt
transfers resources directly from the current young to the current old.
We will examine how introduction of social securities modi…es the

equilibrium conditions of the baseline OLG model.
Pensions and Social Securities: (Contd.)
Recall the baseline OLG structure where an agent born in period t
undertakes the following utility maximization exercise in the …rst
period of his life:
1 2 1 2
Max.U (ct,t , ct,t +1 ) u (ct,t ) + βu (ct,t +1 ); 0 < β < 1,
subject to
1
ct,t + st = wt ; (2)
2
ct,t +1 = (1 + rt +1 δ)st . (3)
From the optimality conditions is this model, we know:
u 0 (wt st )
= β ( 1 + rt + 1 δ) (4)
u 0 ((1 + rt +1 δ)st )
The dynamics of the model is given by:
st
kt +1 = (5)
(1 + n )
where wt = f (kt ) kt f 0 (kt ); rt +1 = f 0 (kt +1 ).
Pensions and Social Securities: A Fully Funded System
In the fully funded pension/social security scheme, the government at
time t raises some amount dt from every young agent as compulsory
contribution to his social security account.
We shall assume that the pension contribution mandated by the
government remains same across all time periods such that
dt = dt +1 = d for all t.
These funds are then invested and the agents receive some gross
returns, denoted by Rt +1 d, when they are old.
This means the an young agent born in period t undertakes the
following utility maximization exercise:
1 2 1 2
subject to
1
ct,t + st = wt d; (6)
2
ct,t +1 = (1 + rt +1 δ)st + Rt +1 d. (7)
Social Securities: A Fully Funded System (Contd.)
Total funds collected by the goverment in the pension account at
time t is:Dt = d Nt
Since the only productive asset of the economy is the capital stock,
the government can only invest the collected social security funds in
capital formation.
Hence apart from private savings, we now also have government
savings, which means:
s t Nt + D t st + d
kt +1 = = (8)
Nt +1 (1 + n )
Moreover, since the government is investing in the same market as
the private agents: Rt +1 (1 + rt +1 δ).
Let us now de…ne the total savings by the young agent by
ŝt = st + d
where st is the fund kept in his private savings account and d is the
contribution that is kept in his pension account.
Then the optimization exercise of an young agent born in period t
can be re-written as:
1 2 1 2
subject to
1
ct,t + ŝt = wt ; (9)
2
ct,t +1 = (1 + rt +1 δ)ŝt . (10)
Then from the optimality conditions:
u 0 (wt ŝt )
= β ( 1 + rt + 1 δ) (11)
u 0 ((1 + rt +1 δ)ŝt )
And the dynamics of the model is given by:
ŝt
kt +1 = (12)
(1 + n )
where wt = f (kt ) kt f 0 (kt ); rt +1 = f 0 (kt +1 ).
Note that the equilibrium condition for the baseline OLG without
social securities - equations (2), (3), (4) and (5), - are identical to the
equilibrium conditions under the fully funded social securities -
equations (9), (10), (11) and (12).
Hence they will generate identical solutions.
In other words, fully funded social security system has no e¤ect
on the total savings and capital formation of the economy.
The reason is clear: when the government mandates some savings
through a pension fund, optimizing agents simply cut down their
private savings by an equivalent amount.
Since the social security system provides a rate of return identical to
that on private savings, the agents are indi¤erent about who
undertakes the savings - they themselves or the government.
But despite the fall in private savings, domestic capital formation
remains the same: the fall in private savings is exactly matched by the
corresponding government savings.
This imples that a fully funded pension scheme will NOT be able
to address the potential dynamic ine¢ ciency problem in the
OLG framework:
If the households were oversaving earlier, the same oversaving problem
will show up now as well!
Of course, now the oversaving will happen through the combined
channel of private savings and government savings - but the
ine¢ ciency or overaccumulation will persist.
Note that if the government had access to a market other than the
domestic capital market to invest its funds - say, an international
captial market - then this problem may have been attenuated.
In that case, domestic capital formation would have come down (since
pension funds are not invested domestically).
At the same time, old generation would have been able to enjoy more
consumption funded through government investment outside.
But this channel is ruled out in a closed economy!
Social Securities: A Pay-As-You-Go System
Things are quite di¤erent with a pay-as-you-go (unfunded) social
security.
Now the government collects dt from every young at time t and
distributes it to the current old in the same time period.
Thus it is a direct tax and transfer across two di¤erent sets of
population in the economy, and there is no investment involved.
By this scheme, each old agent at time t gets a transfer:
dt Nt
bt = = dt ( 1 + n )
Nt 1
We have assumed that the pension contribution mandated by the
government remains same across all time periods such that
dt = dt +1 = d for all t.
Thus
bt + 1 = dt + 1 ( 1 + n ) = d ( 1 + n )
Social Securities: A Pay-As-You-Go System (Contd.)
Hence under the pay-as-you-go system, an young agent born in period
t undertakes the following utility maximization exercise:
1 2 1 2
subject to
1
ct,t + st = wt d; (13)
2
ct,t = (1 + rt +1 δ)st + bt +1 = (1 + rt +1 δ)st + (1 + n)d (14)
+1
Note that now the return on private savings is di¤erent from the
return on pension funds.
In fact, the (gross) return from private savings is (1 + rt +1 δ) while
that from pension funds is (1 + n ) .
How is the government able to fund this return? Because of
population growth!
Recall that population growth implies extra output (more hands to
work or ‘demographic dividend’)!
So the government is now taking away a part of this extra output and
redistributing it to the old.
This seems like double exploitation of the workers:
Note that positive population growth in any case means ceteris
paribus lower capital-labour ratio and therefore lower wages (recall the
positive externality from young to old?)!
On top of that they have to now pay a tax on their wage income!
Why would young agents agree to such a scheme?
They would, because they know that they will also get a similar
transfer when they are old; so they can currently consume a larger
part of their (albeit smaller) wage income, and enjoy more consumption
at old age by exploiting the young generation of the next period!
Indeed once the government announces such a scehme, the agents will
internalise that and will adjust their private savings appropriately. In fact,
they are likely to cut down on their private savings because the government
is taking care of part of their old age consumption needs.
Moreover when (1 + n ) > (1 + rt +1 δ), they might be more willing to
cut down on their private savings, because government is o¤ering them a
higher return than the market.
To see exactly what is the magnitude of this adjustment, we have to

solve the agent’s optimization problem under pay-as-you-go system.
We’ll take it up in the next class.

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Output Dynamics with Heterogenous Agents:

Impact of Income/Wealth Inequality in Solow, R-C-K and OLG

Lecture 14, EC004, DSE

April 12, 2024

The corresponding (non-trivial) steady state solution is given by:

In contrast, recall that in the R-C-K model with population growth,

Hence in the R-C-K framework, consumption tomorrow would rise,

Now let us consider a situation where the (net) return to capital in

This implies that the marginal product of capital is such that

In other words, this is a scenario where the economy is in a

Can an economy remain stuck in such a dynamically ine¢ cient

We now turn to a discussion of some possible policies and the e¢ cacy.

An important policy debate in this context revolves around how the

We will examine how introduction of social securities modi…es the

To see exactly what is the magnitude of this adjustment, we have to

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