Macroeconomics 1

Overlapping Generations Model

Sargam Gupta

IGIDR

Fall Semester, 2023

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 1 / 22

Introduction

Neoclassical growth model with infinite horizon provides a normative

benchmark and a tractable framework for analyzing capital
accumulation.
Is infinitely lived representative household a realistic feature?
Overlapping generations where older and younger generations coexist
for some time period.
OLG models were introduced and studied by Paul Samuelson and
Peter Diamond.
Implications of OLG model is different from that of the RCK model.

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 (a) Paul Samuelson (b) Peter Diamond
(1915-2009) (1940-)

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Key features

Interactions of different generations of individuals in the marketplace.

Provides a tractable alternative to the infinite horizon representative
agent models.
Dynamics of capital accumulation and consumption are quite similar
to the Solow model than to neoclassical growth model.
Generate new insights about the role of national debt and social
security in the economy.

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Baseline Model I
Reference: Chapter 9 (DA), Chapter 2 Romer
Time is discrete and runs to infinity
Each individual lives for two periods
All individuals born at time t live for dates t and t + 1. During the
time period t (their youth), they work and in t + 1 (their old age)
they retire from the labor force.
Individuals consume in both periods, they save in during youth and
dissave in old age.
General utility function for individuals born at time t

Ut (C1 (t), C2 (t + 1)) = U(C1 (t)) + βU(C2 (t + 1))

C1 (t) is the consumption of an individual born at time t when young

(at date t); C2 (t + 1): consumption of an individual born at time t
1
when old (at date t + 1); β ∈ (0, 1) is the discount factor. β = (1+ρ)
Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 5 / 22
Baseline Model II

Factor markets are competitive

Individuals can only work in the first period of their lives and they
supply one unit of labour inelastically, earning the equilibrium wage
rate w (t). In the first period, they make consumption-saving choices
and in the second period they consume savings and the interest rate
they earn.
Suppose also that there is exponential population growth and in
particular, the size of generation 0 t 0 (born in time t ) is

L(t) = (1 + n)t L(0)

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 6 / 22

Baseline Model III
The production side is the same as in Solow, (satisfying assumption 1
& 2 in the Solow model)

Y (t) = F (k(t), L(t))

Employment at time t is same as size of young at this date L(t)

K
k=
L
(δ = 1 capital depreciates fully after use)

(1 + r (t)) = R(t) = f 0 (k(t)) (1)

where f (k) = F (k, 1) and wage rate

w (t) = f (k(t)) − k(t)f 0 (k(t) (2)

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Baseline Model IV

max = U(C1 (t)) + βU(C2 (t + 1))

C1 (t),C2 (t+1),s(t)

C1 (t) + s(t) ≤ w (t)

C2 (t + 1) ≤ R(t + 1)s(t)
C2 (t + 1) ≥ 0
The gross rate of return they receive on their savings are

R(t + 1) = 1 + r (t + 1)

(there is no altruism or bequest motive)

U(.) is strictly increasing. Both the constraints hold as equality.

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 8 / 22

Optimizing Conditions

First order condition:

U 0 (C1 (t)) = βR(t + 1)U 0 C2 (t + 1)

s(t) = h(w (t)(+) , R(t + 1)(+/−) )

Economy savings ⇒ S(t) = s(t)L(t)
Law of motion of the capital stock,

K (t + 1) = L(t)s(w (t), R(t + 1))

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 9 / 22

Competitive Equilibrium

Definition of equilibrium
A competitive equilibrium can be represented by sequences of aggregate
capital stocks, household consumption, and factor prices
{K (t), C1 (t), C2 (t), R(t), w (t)}∞t=0 , such that the factor price sequence
{R(t), w (t)}∞ t=0 is given by (1) and (2), individual consumption decisions
∞
{C1 (t), C2 (t)}t=0 are given by Euler equation and saving per person above
and the aggregate capital stock {K (t)}∞ t=0 evolves according to LOM
above.

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 10 / 22

Fundamental LOM of the OLG economy
K
A steady state equilibrium is defined where capital-labor ratio k = L
is constant.
Divide LOM at time t + 1 by labour supply.

L(t + 1) = (1 + n)L(t)

s(w (t), R(t + 1))

k(t + 1) =
(1 + n)
s(f (k(t)) − k(t)f 0 k(t), f 0 (k(t + 1)))
k(t + 1) =
(1 + n)
A steady state equilibrium is where k(t + 1) = k(t) = k ∗ , that is,

s(f (k ∗ ) − k ∗ f 0 (k ∗ ), f 0 (k ∗ ))
k∗ =
(1 + n)
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Steady State in OLG

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Example: CRRA Utility function

Assume Utility takes CRRA form

C1 (t)1−θ − 1 C2 (t + 1)1−θ − 1
Ut (C1 (t), C2 (t + 1)) = + β( )
1−θ 1−θ
where θ > 0 and β ∈ (0, 1).
Assume technology is Cobb-Douglas

f (k) = k α

The first order condition implies:

C2 (t + 1) 1
= (βR(t + 1)) θ
C1 (t)

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 13 / 22

Example (Contd...)

Alternately,
s(t)−θ βR(t + 1))1−θ = (w (t) − s(t))−θ

w (t)
s(t) =
ψ(t + 1)
where
−1 −(1−θ)
ψ(t + 1) = [1 + β θ R(t + 1)) θ ]>1
which ensures savings are less than earnings.

s(t) w (t)
k(t + 1) = =
(1 + n) (1 + n)ψ(t + 1)

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 14 / 22

Optimal Savings

The impact of factor prices on savings is summarized by the following

derivatives:
∂s(t) 1
sw = = ∈ (0, 1)
∂w (t) ψ(t + 1)
and
∂s(t) 1−θ −1 s(t)
sR = =( )(βR(t + 1)) θ )
∂R(t + 1) θ ψ(t + 1)

Note that 0 < sw < 0. But sR < 0 if θ > 1, sR > 0, if θ < 1 and
sR = 0 if θ = 1
θ > 1 income effect of R dominates but when θ < 1 substitution
effect dominates
θ = 1 Log preferences + Cobb Douglas production function is called
canonical OLG model

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Substitution vs Income effect

Substitution effect
(+): As r increases, the return to saving increases, and this leads
individuals to substitute current consumption for future consumption so
that saving increases.

Income effect
(-): As r increases, individuals prefer more current consumption to future
consumption and this will lead to less saving today and more consumption.

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 16 / 22

Steady State

The steady-state for CD production function,

f (k ∗ ) − k ∗ f 0 (k ∗ )
k∗ = −1 −(1−θ)
(1 + n)[1 + β θ f 0 (k ∗ ) θ ]
Define R∗ = α(k ∗ )α−1

(1 − α)k ∗ α
k∗ = −1 −(1−θ)
(3)
(1 + n)[1 + β θ (αk ∗ α−1 ) θ ]

Solve for k ∗ .

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 17 / 22

Proposition 1
In the overlapping generations model with two-period lived households,
Cobb-Douglas technology, and CRRA preferences, there exists a unique
steady-state equilibrium with capital-labor ratio k ∗ given by (3), and for
any θ > 0, this steady-state equilibrium is globally stable for all k(0) > 0.

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Case of log preferences (Canonical OLG model)

The income and substitution effect exactly cancel out, such that
changes in interest rate (or changes in capital-labor ratio) have no
effect on the saving rate. This makes the model identical to the basic
Solow model
Ut (C1 (t), C2 (t + 1)) = logC1 (t) + βlogC2 (t + 1)

C2 (t + 1)
= βR(t + 1)
C1 (t)
β
⇒ s(t) = w (t)
1+β
s(t) βw (t) β(1 − α)k(t)α
⇒ k(t + 1) = = =
(1 + n) (1 + n)(1 + β) (1 + n)(1 + β)

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 19 / 22

Social Planner I
The social planner gives ξt weight to generation t. The planner maximizes
the utilities of all generations. Hence the planner’s problem is:
∞
X
ξt Ut (C1 (t), C2 (t + 1))
t=0

It is assumed that,
∞
X
ξt < ∞
t=0

such that the planner’s problem is well behaved. The social planner
maximizes the following wrt {C1 (t), C2 (t + 1), k(t + 1)},
∞
X
ξt (U(C1 (t)) + βU(C2 (t + 1)))
t=0

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Social Planner II

A social planner maximizes agents’ utility subject to economy-wide

resource constraint.
Dividing by L(t) and using (9.2), the economy-wide resource
constraint can be written in per capita terms as

C2 (t)
f (k(t)) = (1 + n)(k(t + 1)) + C1 (t) +
1+n
Social planner’s maximization problem implies

U 0 (C1 (t)) = βf 0 (k(t + 1))U 0 (C2 (t + 1))

R(t + 1) = f 0 (k(t + 1))

The social planner prefers to allocate the consumption of a given
individual in exactly the same way as the individual himself would do.
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Steady State

In the steady state of OLG economy, we have

f (k ∗ ) − (1 + n)k ∗ = C1∗ + (1 + n)−1 C2∗

= C∗
thus

∂C ∗
= f 0 (k ∗ ) − (1 + n)
∂k ∗

f 0 (kgold ) = 1 + n
In the baseline OLG economy, the competitive equilibrium is not necessarily
Pareto optimal. When r ∗ < n, the economy is dynamically inefficient.

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