Monetary Economics II: Theory and Policy ECON 3440C: Tasso Adamopoulos York University

Monetary Economics II: Theory and Policy
ECON 3440C
Tasso Adamopoulos
York University
Fall 2021
Lecture 10
ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 1 / 40

1. Recap: Savings and Investment

Savings Decisions
How do individuals choose their savings?
Standard two-period OLG model in which individuals choose how

much to consume when young and old, (c1,t , c2,t+1 ).
Each individual has endowment of y1 of the good when young

(“current income”), and y2 when old (“future income”).
The young face a gross real interest rate of r .
They choose how much to save st .

Budget Constraints
Budget constraint when young in period t,
c1,t + st ≤ y1
Budget constraint when old in period t + 1,
c2,t+1 ≤ y2 + r · st
Combine the two to get the lifetime budget constraint,

c2,t+1 y2
c1,t + ≤ y1 +
r r
Graph the lifetime budget constraint.

Individual Problem
Choose the optimal (c1,t , c2,t+1 , st ) to maximize lifetime utility

U (c1,t , c2,t+1 ) subject to the lifetime budget constraint, i.e., to attain
the highest possible utility the individual can afford.
This occurs where the highest possible indifference curve U 0 is

tangent to the budget line.
This gives optimal consumption in the two periods of life as (c1∗ , c2∗ ).
From the first period budget constraint we can solve for optimal
savings: s ∗ = y1 − c1∗
Wealth, not income, determines lifetime consumption choices,

y2
wt = y1 +
r

Note relative positions
Go of 994 depend on
individual preference
iif
ya f
1
c
Yi 4,1 42
r G
s I Y Cf
2. Social Security

Social Security Plans
What is the effect of government run pension plans?

Two main ways to finance government social security payments to the old:
1 Fully Funded (FF) Pension Plan:

I government taxes young workers
I uses contributions to buy interest bearing assets
I uses asset returns to finance the pension payments of that same cohort
when old
→ government sponsored savings program.
2 Pay-as-you-go (PAG) Pension Plan:
I government taxes the current young
I uses contributions to make payments to the current old within the
same period
→ involves intergenerational transfers.

Environment
Standard two-period OLG model in which individuals choose how

much to consume when young and old, (c1,t , c2,t+1 ).
Each individual has endowment of y1 of the good when young

(“current income”), and y2 when old (“future income”).
The young face a gross real interest rate of r .
They choose how much to save st .

Fully Funded (FF) Plan
Pension to the old financed by contributions they paid when they

were young.
Represent this plan as:

I a lump-sum tax of τ goods on each young person (contribution)
I which pays for a lump-sum pension of σ goods to each of the same
people when old (benefits)
I the contributions of the young are saved at the market rate of return r
For simplicity there are no other sources of government revenue or

other government expenditures.
Government budget constraint from running the FF program:
Nt · τ · r = Nt · σ ⇒ τ r = σ

FF Plan - Individual Budget Constraints
Budget constraint when young at t,
c1,t + st ≤ y1 − τ
Budget constraint when old at t + 1,
c2,t+1 ≤ y2 + rst + σ
Lifetime budget constraint of individual,

c2,t+1 y2 σ
c1,t + ≤ y1 + −τ +
r | r {z r}
individual wealth in the
presence of the FF plan

FF Plan - Combine Individual and Government Constraints
c2,t+1 y2 τr
c1,t + ≤ y1 + −τ + ⇒
r | r {z r}
plug in government
budget constraint for σ
c2,t+1 y2
c1,t + ≤ y1 +
r | {z r}
same wealth as
without FF plan

Cz a
if
c
Yz go
c
C t Yi Z Y Y t
S C am thou 1 FF
EY
Fey Z C with FF
FF Plan
Individual lifetime wealth unchanged by the FF pension plan.
So individuals are free to choose the same bundle (c1∗ , c2∗ ) as they
would have chosen without the FF plan.
So the FF plan has no effect on consumption and welfare.
Is there an effect on saving?

I Saving without FF (τ = 0),
s ∗ = y1 − c1∗
I Saving with FF (τ > 0),

0
s ∗ = y1 − τ − c1∗ < s ∗

FF Plan
The individual saves less by the amount of the tax contribution,
∆s = −τ
The resulting reduction in savings returns r τ exactly matches the
increased pension when old σ → leaving c2∗ unaltered.
So the government here is acting as a private pension.
When individuals have to increase their contribution to the

government plan, they reduce their voluntary private savings by an
equal amount → FF shifts resources from the private to the
government run pension plan.
If both offer the same rate of return then individuals are indifferent
between the two options (only total matters).
All this assumes that τ < s ∗ . However, if τ > s ∗ individuals are worse
off because they are on a lower indifference curve.
i
Pay-as-you-go (PAG) Plan
Pension to the current old financed by contributions by the current

young.
Represent this plan as:

I a lump-sum tax of τ goods on each young person (contribution) in t
I which pays for a lump-sum pension of σ goods to each old (benefits) in
t
Here the government undertakes no investment on behalf of the old

→ instead it relies on intergenerational transfers.
Government budget constraint from running the PAG program:
total pensions to old in t = total contributions of young in t

Nt
Nt−1 · σ = Nt · τ ⇒ σ = τ ⇒σ =n·τ
Nt−1

period
initial
generatit
O 0
old T
L I o
5 y 0
arrows depict intergenerational

transfers
Pay-as-you-go (PAG) Plan
σ =n·τ
growing population (n > 1) means that there are more young people
than old in each period t.
As a result, each old person can receive more for any given tax paid
by each young.
Total taxes paid by young spread over a smaller number of old.

PAG Plan - Individual Budget Constraints
Budget constraint when young at t,
c1,t + st ≤ y1 − τ
Budget constraint when old at t + 1,
c2,t+1 ≤ y2 + rst + σ
Lifetime budget constraint of individual,

c2,t+1 y2 σ
c1,t + ≤ y1 + −τ +
r | r {z r}
individual wealth in the
presence of the PAG plan

PAG Plan - Combine Individual and Government
Constraints
c2,t+1 y2 τn
c1,t + ≤ y1 + −τ + ⇒
r | r {z r}
plug in government
budget constraint for σ
c2,t+1 y2 hn i
c1,t + ≤ y1 + + τ −1
r | {z r} | r{z }
wealth without PAG PAG related wealth

n T
a
PAG Plan
Do future generations like the PAG system?
The PAG system increases wealth of future generations only if,

hn i
n>r ⇒ −1 >0
r
If n < r then future generations do not like the PAG system because
it reduces their lifetime wealth.
The comparison of n and r is a real rate of return comparison.

I Rate of return on private savings → real interest rate r .
I “Rate of return” of PAG =
what you receive σ nτ
= = =n
what you pay τ τ

PAG Plan
If a young individual opted out of the PAG system they would save
privately the contribution τ (and not receive pension σ) → earn on
the market a rate of return r → total earnings when old of τ r .
If a young individual goes with the PAG system they contribute τ to

the system when young and earn benefit σ = nτ when old.
Better off investing on their own if r > n. then future generations do
not like the PAG system because it reduces their lifetime wealth.
Who would object if the government were to allow individuals to opt

out of the PAG plan?
The current old! ... because they have already contributed in the
past.

3. Effect of National Debt on
Capital and Savings

Question
Two assets through which individuals can save:

I Government bonds
I Capital
If the government increases the stock of bonds does this mean that
people will invest less in capital?
Answer question by examining two cases:

1 Government deficits reduce capital investment.
2 Government deficits have no effect on capital.
The two cases differ only in one assumption: who pays for the
government deficit → assumption key to understanding when the size
of national debt is important to the size of the capital stock.

Environment
Consider the two-period OLG model with endowments (y1 , y2 ) just

developed.
Assume constant population Nt = N for all t.
Capital pays a constant one-period rate of return x.
Government may issue bonds paying the same rate of return as

capital r = x.
At time t each young person pays a lump-sum tax of τ1t goods and
each old person pays a lump-sum tax of τ2t goods.

Constraints
Lifetime budget constraint of individual born in t,

c2,t+1 y2 − τ2t+1
c1,t + ≤ y1 − τ1t +
r r
Government budget constraint in period t (per capita),
gt + rbt−1 = τ1t + τ2t + bt

Policy Experiment
Tax cut of 100 units per young in t,
∆τ1t = −100 < 0
No change in government expenditures,
∆gt = 0
No change in taxes on the current old,
∆τ2t = 0
From the government budget constraint we see that the government

would have to increase the amount of government debt per young in
period t, bt , by an amount equal to the size of the tax cut,
∆bt = −∆τ1t = 100 > 0

Assumption
The debt will be paid off at some future date by some other generation →
not the generation that enjoyed the tax cut → there is no change on the
taxes of the current young when old,
∆τ2t+1 = 0

Effects of Policy Experiment
Effect on wealth: people who receive a tax cut with no later increase
in taxes experience an increase in their after-tax wealth,
∆wt = −∆τ1t = −(−100) = 100 > 0
Effect on consumption: if consumption in each period is a normal

good, the when wealth wt increases there will be an increase in both
consumption levels,
∆c1,t > 0; ∆c2,t+1 > 0
Effect on savings: we know that savings in levels is given by,
st = y1 − τ1t − c1,t
and in change form,
∆st = ∆y1 − ∆τ1t − ∆c1,t ⇒ ∆st = 100 − ∆c1,t < 100

Effect on capital: since there are two assets through which you can
save, capital kt and government bonds bt , in levels we have,
st = kt + bt
Then, in change form it must be that,
∆st = ∆kt + ∆bt
Recall that to finance the tax cut government bonds have risen by
100: ∆bt = 100.
However, saving has increased less than 100:

∆st = 100 − ∆c1,t < 100.

∆st = ∆kt + ∆bt ⇒

100 − ∆c1,t = ∆kt + 100 ⇒
∆kt = −∆c1,t < 0
So capital falls by the increase in consumption when young.
Reason: although the stock of assets (k + b) increased by the number of

bonds issued (= size of tax cut) people did not wish to increase their
savings by the full amount of the tax cut → the extra bonds can be held
then only if people reduce their holdings of capital →
Crowding Out effect of capital

Deficits and Interest Rates
By rate of return equality, r = MPK .
Up to here MPK = x, i.e., fixed → r fixed too.
If instead capital exhibits diminishing MPK then we can also see the
effect of government debt on r .
With a diminishing MPK we have f 00 (k).
Rate of return equality implies,
r = f 0 (k)
which is an inverse relationship between r and k.
So if government debt increases → ↓ kt → ↑ MPKt = f 0 (kt ) → ↑ rt

Recoil
MPK with returns

D diminishing
DCMPK
to or f f SO
k 12
2 Rate of Return Equality

r MPK
i
it
Deficits and Interest Rates
When government debt increases, savings st increase by less than bt

increases → for given r the supply of st increases by less than the
demand for st .
In a free market the supply cannot exceed the demand.
Government has to offer a higher r to entice savers away from k with

MPK < r → crowding out of capital.

4. Neutral Government Debt

Alternative Assumption
Change in assumption that will remove the crowding out effect on

capital:
I The debt created at t will be repaid by taxing the old at t + 1 (not
future generations).
Now the tax to repay the debt falls on the generation that enjoyed
the tax reduction.

Comparing Plans
Analyze the case by comparing the lifetime budget constraint of an

individual under two fiscal plans that provide the same gt per young
person.
General lifetime budget constraint of an individual,
c2,t+1 (y2 − τ2t+1 )

c1,t + ≤ (y1 − τ1t ) +
r r

Plan A
Government pays for entire gt in t by taxing the young for the full
amount:
τ1 = gt
Since government expenditures completely financed by current taxes,
no need for government to borrow:
bt = 0
No need to impose taxes in the following period on the old:
τ2 = 0
Lifetime budget constraint of an individual,

c2 y2
c1 + ≤ y1 − g +
r r

Plan B
Government does not tax the young at all for the financing of gt in t:
τ1 = 0
The government must then issue debt (borrow) for the entire amount
to finance gt :
bt = g t
To retire the debt with interest in the next period t + 1, the
government needs to impose taxes on the old in t + 1:
τ2 = rbt
Lifetime budget constraint of an individual,

c2 y2 τ2 y2
c1 + ≤ y1 + − = y1 + −g
r r r r

Implications from comparison
The individual lifetime budget constraint is the same under the two
plans.
The deficit funded tax cut does not change the lifetime wealth of
generation t:
I the increase in disposable income from tax cut when young is exactly
offset in present value terms by the drop in disposable income from the
tax raise when debt is retired.
Generation t pays for the entire government expenditure in both

plans.

Effects on key variables from debt creation
Lifetime wealth wt same with or without deficit.
Individuals choose the same consumptions: c1,t and c2,t+1 .

I people do not consume any part of the their tax cut when young,
∆c1,t = 0
They save the entire tax cut in anticipation of the future tax hike that
will be required to pay off the deficit,
∆st = ∆bt

Effects on deficit on capital
Savings of the individual in levels,
st = kt + bt
Changes in individual savings,
∆st = ∆kt + ∆bt
Bonds bt increase by,

∆bt = ∆τ1t
Since the entire tax cut is saved, savings increase by the increase in
bonds,
∆st = ∆bt
No crowding out effect on capital,
∆kt = 0
No effect on MPK or the real interest rate r .

Notes
The desire to save increased by exactly as much as the increase in

bonds, so that the government did not need to offer a higher r to
entice people to hold bonds.
Conclusion: a deficit-financed tax cut has no effect on real variables

(c1 , c2 , k) here →
→ Ricardian Equivalence Theorem

Notes
Crucial difference between the two cases (effect on k vs. no effect on k):
in the first case, the tax cut alters real variables because individuals
who benefit from the tax cut do not have to pay for the tax increase
when the debt is retired → individuals experience ↑ wt → ↑ c1,t and
↑ c2,t+1 .
in second case, individuals pay higher tax when old when debt is
retired → ∆wt = 0 → ∆c1,t = ∆c2,t+1 = 0.
So the effects of bond financed tax cuts depend on whether the

people who receive the tax cut will live to pay for the increase in taxes
that will retire the resulting debt.

Monetary Economics II: Theory and Policy ECON 3440C: Tasso Adamopoulos York University

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Monetary Economics II: Theory and Policy

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 1 / 40

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 2 / 40

How do individuals choose their savings?

Standard two-period OLG model in which individuals choose how

Each individual has endowment of y1 of the good when young

The young face a gross real interest rate of r .

They choose how much to save st .

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 3 / 40

Budget constraint when young in period t,

Budget constraint when old in period t + 1,

Combine the two to get the lifetime budget constraint,

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 4 / 40

Choose the optimal (c1,t , c2,t+1 , st ) to maximize lifetime utility

This occurs where the highest possible indifference curve U 0 is

Wealth, not income, determines lifetime consumption choices,

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 5 / 40

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 6 / 40

What is the effect of government run pension plans?

1 Fully Funded (FF) Pension Plan:

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 7 / 40

Standard two-period OLG model in which individuals choose how

Each individual has endowment of y1 of the good when young

The young face a gross real interest rate of r .

They choose how much to save st .

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 8 / 40

Pension to the old financed by contributions they paid when they

Represent this plan as:

For simplicity there are no other sources of government revenue or

Government budget constraint from running the FF program:

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 9 / 40

Budget constraint when young at t,

Budget constraint when old at t + 1,

Lifetime budget constraint of individual,

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 10 / 40

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 11 / 40

Individual lifetime wealth unchanged by the FF pension plan.

So the FF plan has no effect on consumption and welfare.

Is there an effect on saving?

I Saving with FF (τ > 0),

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 12 / 40

So the government here is acting as a private pension.

When individuals have to increase their contribution to the

Pension to the current old financed by contributions by the current

Represent this plan as:

Here the government undertakes no investment on behalf of the old

Government budget constraint from running the PAG program:

total pensions to old in t = total contributions of young in t

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 14 / 40

arrows depict intergenerational

Total taxes paid by young spread over a smaller number of old.

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 15 / 40

Budget constraint when young at t,

Budget constraint when old at t + 1,

Lifetime budget constraint of individual,

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 16 / 40

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 17 / 40

Do future generations like the PAG system?

The PAG system increases wealth of future generations only if,

The comparison of n and r is a real rate of return comparison.

ECON3440C - Adamopoulos Monetary Economics, Lecture 10 2021 18 / 40

If a young individual goes with the PAG system they contribute τ to