4  Simulation results

4.1  The impact of ageing on living standards

We define living standards as consumption per equivalent person, using the age-specific consumption weights described above to calculate the population in equivalent persons. Ageing affects living standards through three mechanisms: the dependency effect, the capital-widening effect, and the capital intensity effect (Elmendorf and Sheiner 1999). The dependency effect describes the lower consumption possibilities that result from fewer workers relative to consumers. This is evident from (11) in which a lower support ratio, α, implies lower steady state consumption for any given capital-output ratio. The capital widening effect refers to the lower capital requirements of a more slowly growing labour force. In terms of (11), J(i) is lower allowing a higher value of c. Hence the capital-widening effect increases consumption possibilities. The capital intensity effect is a transitional effect as the smaller labour force temporarily increases the capital-labour ratio (or capital intensity). The higher capital-labour ratio lowers the marginal product of capital which reduces investment relative to saving and hence lowers the current account deficit. The lower current account deficit implies lower foreign liabilities, other things constant, implying a lower interest rate via (7). This in turn lowers the return to saving and raises current consumption. This effect unwinds as the economy works off the excess capital. Hence both the capital intensity effect and the capital widening effect provide temporary boosts to consumption which partially offset the dependency effect.

Figure 8 - Decomposition of the effects of ageing on living standards for base population variant

Source:

The paths of the three effects on living standards are illustrated in Figure 8. The size of each effect is calculated by decomposing the following identity:

(15)    

where y=f(k). The dependency effect is approximated[13] by , where 0 refers to the initial levels and 1 refers to the post-shock levels. This gives the net effect of a reduction in youth dependency and an increase in old age dependency. The capital widening and capital intensity effects are given by, respectively, and . As Figure 8 illustrates, the dependency effect is negative throughout the planning horizon and far outweighs the other two effects.

Figure 8 shows total optimal consumption reaching a new steady state some 16% below the initial steady state. This is the long run impact of population ageing on living standards. The speed at which consumption adjusts to the new steady state level depends on the change in the rate of return on saving (i.e. the interest rate) in response to ageing and on the elasticity of substitution in consumption (equal to 1/β). The change in the return on saving is determined by the parameter λ in (7). In the case where the return to saving is exogenous, as it is in the case of a zero interest rate premium (where λ=0), the return to saving does not respond at all, allowing complete consumption smoothing; hence in that case consumption adjusts instantly to its new steady state level.[14] The elasticity of substitution in consumption affects the path of consumption through the degree of consumption smoothing: the higher the elasticity, the more that future consumption is discounted, implying more consumption smoothing and hence a faster speed of adjustment of consumption to its new steady state level.

Table 6 gives the magnitude of the effect of ageing on living standards at different stages over the next 100 years. It gives the results for the demographic assumptions described above: the base case, a low fertility scenario, a low mortality scenario and a high immigration scenario. It also gives results for base case demographics under alternative values of the elasticities of substitution in production and consumption, and for alternative values of λ, including the small open economy case where λ=0.

As indicated in the top left hand column of Table 6, by the year 2051, assuming base case demographics, population ageing will have reduced living standards by 12% from the level that they would have reached in the absence of population ageing. Nevertheless, living standards can be expected to approximately double by 2051 under base case demographics (see middle section of Table 6, left hand column). As the table shows, this result is quite insensitive to alternative demographic assumptions and alternative parameter values. Another way of describing the ageing effect is in terms of the equivalent loss of labour productivity growth. As the bottom section of Table 6 indicates, by 2051 population ageing will have reduced living standards by the equivalent of an annual reduction in productivity growth[15] of 0.24% with base case demographics. This would amount to a reduction from, for example, 1.5% p.a. to 1.26% p.a. Another way of saying this is that productivity growth would have to fall from 1.5% p.a. to 0.24% p.a. – that is, almost zero productivity growth year after year for 50 years – for living standards in 2051 to be below their level in 2001 on account of population ageing.

Such an apparently sanguine assessment of the effect of ageing on living standards is only as robust as the assumptions allow. However, the sensitivity analysis reported in Table 6, for alternative demographic scenarios and alternative parameter values, shows little variation in the effect of ageing on living standards. The largest variation in living standards compared with the base case occurs in the small open economy scenario (λ=0). This is because the adjustment to a lower rate of consumption occurs immediately resulting in a relatively big initial loss of living standards but a smaller loss of living standards later on. For example, the loss of living standards by 2011 is nearly three times as big as in the base case but by 2051 living standards are 25% higher than in the base case.