Working Paper: NBER ID: w26943
Authors: Joseph 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: population aging; risk-free rate; equity risk premium; lifecycle model
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) | Decline in the risk-free rate (E43) |
| Decline in the risk-free rate (E43) | Increase in the equity risk premium (G19) |
| Aging demographics (J11) | Increase in the equity risk premium (G19) |
| Lifecycle savings dynamics (D15) | Decline in the risk-free rate (E43) |
| Portfolio reallocation as households age (D14) | Increase in the equity risk premium (G19) |