Working Paper: CEPR ID: DP14576
Authors: Joseph V. Kopecky; Alan M. Taylor
Abstract: Population aging has been linked to global declines in real interest rates. A similar trend is seen for equity risk premia, which are on the rise. An existing literature can explain part of the declining trend in safe rates using demographics, but has no mechanism to speak to trends in relative returns on different assets. We calibrate a heterogeneous agent life-cycle model with equity markets and aggregate risk, and we show that aging demographics can simultaneously account for both the majority of a downward trend in the risk free rate, while also increasing the return premium attached to risky assets. This is because the life-cycle savings dynamics that have been well documented exert less pressure on risky assets as older households shift away from risk. Under reasonable calibrations we find declines in the safe rate that are considerably larger than most existing estimates between the years 1990 and 2017. We are also able to account for most of the rise in the equity risk premium. Projecting forward to 2050 we show that persistent demographic forces will continue push the risk free rate further into negative territory, while the equity risk premium remains elevated.
Keywords: lifecycle model; OLG model; demographics; rates of return; safe assets; risky assets; secular stagnation
JEL Codes: E21; E43; G11; J11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Aging demographics (J11) | Shift in asset allocation (G11) |
| Shift in asset allocation (G11) | Decline in risk-free rate (E43) |
| Aging demographics (J11) | Decline in risk-free rate (E43) |
| Aging demographics (J11) | Increase in equity risk premium (G19) |