Charles R. Bean

English

Research Papers in Economics

“I am an old man and have known a great many troubles, 
but most of them never happened.”
—Mark Twain
My brief is to discuss the implications of population aging for
monetary policy. But before doing that, let us recall some of the
things we have learned at this symposium about the macroeconomic
impact of demographic change.
Macroeconomic effects of aging
To begin with, there are three demographic shocks working their
way through: reduced fertility rates, increased longevity, and the
temporary increase in fertility that followed World War II. The effects
of these shocks differ, as do their importance across countries. The
advanced economies and, somewhat later, China will be most
affected by population aging in the coming decades. In contrast,
some developing countries should see a rising share of the working-
age population. The paper by David Bloom and David Canning
highlighted the opportunities provided to the latter by this “demo-
graphic dividend.”
Charles R. Bean
Overview
447As far as the consequences of aging go, several contributors have
suggested that the affected countries should experience a fall in the
growth rate of per capita GDP and changes in saving and investment.
Aggregate saving is likely to rise along the transition path as working
households prepare for a longer expected retirement. But as those
households move into retirement and dissave, aggregate saving should
drop back. Life-cycle theory suggests the aggregate saving ratio should
be lower in the long run, as the dissaving retirees will be more numer-
ous. That seems to be supported by some macroeconometric studies,
although, as previously discussed, some of the microeconometric
evidence is rather less supportive in finding that the elderly do not
dissave as much as the theory predicts. Finally, the capital intensity of
production should rise and the equilibrium rate of return should fall.
The graying of the population could also affect the supply of labor.
Increased longevity should lead both to more time spent in retire-
ment and to more time spent in work as people increase their saving
in order to maintain their consumption in old age. And we know that
wages rise with experience, suggesting that an older workforce should,
on average, be more productive, even if in some lines of work produc-
tivity may decline beyond a certain age. 
The magnitude of these effects depends critically on the degree of
openness, on the international correlation of the demographic
shocks, and on the response by governments. With a high degree of
openness, the common component of the changes in savings and
investment behavior will affect the global real rate of return, while the
asymmetric components should show up in movements in current
account balances and real exchange rates. In addition, the relative
scarcity of workers in countries with aging populations should drive
up real wages, prompting increased inward migration from countries
where labor is more abundant. Those themes were explored in the
contributions from Ralph Bryant and John Helliwell. 
As far as policy goes, countries that rely heavily on unfunded state
pension schemes—as many European states still do—will be forced
448 Charles R. Beaneither to lower pension benefits or else raise taxes on the working
population. The natural consequence of lower state pensions will be
greater reliance on private provision. In that regard, though, it is
worth noting that some funded private pension schemes have already
run into difficulty because of unanticipated increases in longevity. On
the other hand, if taxes are raised to preserve the value of pensions,
then there may be adverse effects on labor supply and entrepreneur-
ial activity. Finally, government policy toward retirement dates will be
key, as an obvious response to increased longevity is to increase the
length of the average working life. Given the required size of adjust-
ment, action along a variety of dimensions seems the most likely
eventual outcome. 
Implications for central banks: demography as a source of shocks
So, how does all this affect central banks? First, demographic
change represents a macroeconomic shock. But the glacial nature of
demographic change appears to suggest that the implications for
monetary policy should be modest. Saving ratios are more likely to
drift up or down over many years or even decades rather than change
abruptly. The same is true of developments in current accounts, real
exchange rates, migration, and labor force participation. 
But though the demographic changes will be drawn out, income
expectations or the institutional environment could shift more
abruptly. Dealing with the consequences of an aging population is
one of the trickier economic problems facing governments, particu-
larly in countries with generous unfunded pension schemes. Given
the glacial nature of demographic change, it will be tempting to post-
pone sensitive decisions. Don Johnston’s reference to the inaction by
OECD governments on this front over the last six years highlights the
possibility that decisive action may only be triggered as public debt
spirals and the financial markets start worrying about monetization
or default. Abrupt movements in asset prices and sharp movements
in saving behavior could then be the result.
Overview 449Even where there is less reliance on state provision, there could be
quite sharp changes in expectations and the environment. In the
United Kingdom, for instance, increased longevity and falls in equity
prices have led to the closure of many defined benefit company
pension schemes, with the attendant transfer of risk from employer to
employee. Part of the response to that has been increased investment
in real estate and an expansion of “buy-to-let” as a means of provid-
ing for retirement. That has added to the upward pressure on house
prices, something that the Bank of England’s Monetary Policy
Committee has been much exercised about recently.
Natural rates
Second, demographic developments will affect the natural rate of
interest and the natural rate of unemployment, the reference points
we habitually use to judge the stance of monetary policy. As already
noted, the analysis presented at this symposium points to a lower
natural real rate of interest, both along the transition path and in the
steady state. But is the impact likely to be quantitatively significant?
Axel Börsch-Supan’s simulations for the European Union point to a
decline of around one and a half percentage points in the real rate
over the next 30 years. On the other hand, David Miles (1999) finds
an effect only a third that size in a similar model. Moreover, the
results that Jim Poterba presented in his paper suggest there is little
evidence of a strong statistical link between demographic variables
and the rate of return in the United States. Clearly, there is much
uncertainty here, but it is worth pointing out that we have seen much
larger movements in long-run real interest rates over the last decade,
reflecting the impact of factors such as the acceleration in productiv-
ity and changes in budgetary positions.
That the natural rate of unemployment may also be affected is less
obvious. However, the aging of the population means that the rate of
inflow into the working population and the exit rate into retirement
will both be lower in the long run. The former tends to lower the
natural rate, as there will be relatively fewer unemployed young
450 Charles R. Beanworkers looking for jobs. Whereas the latter raises it as there are fewer
vacancies arising out of retirement. In standard matching models (see
Christopher Pissarides 2000) the first effect dominates, so the natural
rate should fall. In addition, the changing age structure of the
working population is likely to affect average quit rates. For instance,
we know that average job duration tends to be shorter for younger
workers than older workers. If younger workers constitute a smaller
share of the workforce, then the average quit rate and the natural rate
of unemployment should both be lower. But whether these effects are
quantitatively significant is another matter altogether. Moreover, they
may well be offset by worsening skill mismatch if there are some
workers whose productivity declines sharply after a certain age and
that interacts with generous unemployment benefits—a problem
alluded to in discussion by Alan Blinder.
The transmission mechanism: the impact of interest rates 
on demand
A third route whereby a grayer population may have an impact on
the conduct of monetary policy is through its impact on the transmis-
sion mechanism. Changes in interest rates affect consumer spending
through three channels: wealth effects, intertemporal substitution,
and the interaction of cash flow and credit constraints. Now, the old
are typically richer in financial and real capital, while the young are
richer in human capital. Moreover, the marginal propensity to
consume out of wealth should rise with age. So, wealth effects should
be more important for the old. In contrast, the young are less likely
to own assets that can be used as collateral and more likely to be
subject to credit constraints.
So, an aging population means the wealth channel is likely to
become relatively more important compared with the intertemporal
substitution and credit channels. Increased longevity should also lead
older workers to carry even higher levels of financial wealth into
retirement, further accentuating the wealth effect. But whether that
leads to an overall rise or fall in the monetary policy multiplier is less
Overview 451obvious. David Miles (2002) reports simulations with an overlap-
ping-generations model that suggest the policy multiplier will indeed
rise. But in the United Kingdom, with its high levels of home owner-
ship financed through variable rate borrowing, the impact of higher
interest rates on the cash flow of constrained borrowers and on the
value of housing collateral appears to be a particularly important part
of the transmission mechanism. In that case, the monetary policy
multiplier could well fall.
The transmission mechanism: the Phillips curve
A grayer population could also affect the transmission mechanism
by flattening the short-run Phillips curve. There are two possible
mechanisms at work. First, as already noted, workers may want to
work longer in order to provide for their retirement. In addition, so
long as the state retains some responsibility for supporting the elderly,
governments are likely to want to extend the typical working life in
order to keep the tax burden down. But a substantial increase in
mandatory retirement dates seems relatively unlikely. Rather, as Don
Johnston noted, governments are likely to combine more modest
increases with fiscal inducements that encourage potential retirees to
continue working in some form after the normal retirement age. The
participation and supply of hours from these workers is likely to be
more elastic than those of prime-age workers, leading to an increase
in the cyclical responsiveness of overall labor supply and a flatter
Phillips curve.
The second mechanism is through inward migration into the aging
developed economies. Now, any such migration will most likely be
mainly a steady flow. But, to the extent that such migration responds
to job availability in the receiving countries, then it will act as a safety
valve when they start overheating. The potential for a country to grow
rapidly without significant upward pressure on inflation by taking
advantage of inward migration is illustrated by the experience of the
Republic of Ireland over the last 15 years—a sort of reverse diaspora as
Irish workers on the British mainland and elsewhere returned home. 
452 Charles R. BeanThe political economy of inflation
A fourth impact of aging on central banks may be through its
impact on the constituency for low inflation. Other things equal,
increased longevity should lead not only to more retirees but also to
higher average wealth holdings. That will be even more likely if
governments respond to aging by cutting back on the generosity of
state pensions and encouraging greater private provision. Moreover,
employers in countries like the United Kingdom have been shifting
pension arrangements from a defined benefit basis to one of defined
contribution. Workers saving for retirement will therefore typically
find themselves exposed to more risk than before. In order to hedge
some of that risk, they are likely to want to hold a greater fraction of
their portfolios in bonds rather than equity and, assuming that the
majority of bonds remain nominally denominated, the constituency
for keeping inflation low will be larger. 
Financial stability
The fifth dimension of the impact on aging on central banks relates
to their role as guardians of the stability of the financial system. An
aging population, particularly if it is also associated with a move from
unfunded to funded pension schemes, implies a higher saving rate for
the population of working age. Moreover, those funds are likely to be
channeled through institutional investors rather than banks, hastening
the structural changes that are already taking place in bank-dominated
capital markets such as those in some euro-area countries. 
The greater scope for diversification and risk-shifting with securi-
tized lending rather than bank-intermediated finance means that, in
principle, this could be a positive development from a financial stabil-
ity perspective. But against that, it may be harder to trace exactly
where some kinds of risk end up. So, at a minimum, central banks
will need to develop further their antennae for the surveillance of
macro-prudential risks.
Overview 453Furthermore, increased reliance on personal pension provision will
increase the sensitivity of savers to underperformance, whether it
results from fraudulent behavior, the misguided use of funds, or just
plain bad luck. Financial supervisors should expect to receive height-
ened criticism for perceived regulatory failings. And monetary
policymakers can expect to be criticized for allowing asset prices to fall. 
But let me conclude by noting a sixth and final impact of increased
longevity on central banks that I see as quite unambiguously benefi-
cial: Namely, that it allows even older and wiser chairmen and
governors to run the show!
References
Miles, David. “Modeling the Impact of Demographic Change upon the Economy,”
Economic Journal, vol. 109, 1999, pp. 1-36.
__________. “Should Monetary Policy be Different in a Greyer World?” in Ageing,
Financial Markets and Monetary Policy, Alan Auerbach and Heinz Hermann,
eds., Springer, 2002.
Pissarides, Christopher A. Equilibrium Unemployment Theory. MIT Press, 2000.
454 Charles R. Bean

Modeling the Impact of Demographic Change upon the

Global demographic change : some implications for central banks : overview panel

http://www.kansascityfed.org/Publicat/sympos/2004/pdf/Bean2004.pdf

Global demographic change : some implications for central banks : overview panel

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