Overlapping generations model
An overlapping generations model, abbreviated to OLG model, is a type of representative agent economic model in which agents live a finite length of time long enough to overlap with at least one period of another agent's life.
All OLG models share several key elements:
- Individuals receive an endowment of goods at birth.
- Goods cannot endure for more than one period.
- Money endures for multiple periods.
- Individual's lifetime utility is a function of consumption in all periods.
The concept of an OLG model was inspired by Irving Fisher's monograph The Theory of Interest. Notable improvements were published by Maurice Allais in 1947, Paul Samuelson in 1958, and Peter Diamond in 1965.
The most basic OLG model has the following characteristics:
- Individuals live for two periods; in the first period of life, they are referred to as the Young. In the second period of life, they are referred to as the Old.
- A number of individuals is born in every period.Ntt denotes individuals born in period t.
- Nt-1t denotes number of old people in period t. Since the economy begins in period 1. In period 1, there is a group of people who are already old. They are referred to as the initial old. They can be denoted as N0 .
- The size of the initial old generation is normalized to 1 i.e. N 00 = 1.
- People do not die early, N tt = N t-1t+1.
- Population grows at a constant rate n:
- There is only one good in this economy, and it cannot endure for more than one period.
- Each individual receives a fixed endowment of this good at birth. This endowment is denoted as y. This endowment of goods can also be thought of as an endowment of labor that the individual uses to work and create a real income equal to the value of good y produced. Under this framework, individuals only work during the young phase of their life.
- Preferences over consumption streams are given by
where is the rate of time preference.
One important aspect of the OLG model is that the steady state equilibrium need not be efficient, in contrast to general equilibrium models where the First Welfare Theorem guarantees Pareto efficiency. Because there are an infinite number of agents in the economy, the total value of resources is infinite, so Pareto improvements can be made by transferring resources from each young generation to the current old generation. Not every equilibrium is inefficient; the efficiency of an equilibrium is strongly linked to the interest rate and the Cass Criterion gives necessary and sufficient conditions for when an OLG competitive equilibrium allocation is inefficient.
Another attribute of OLG type models is that it is possible that 'over saving' can occur when capital accumulation is added to the model—a situation which could be improved upon by a social planner by forcing households to draw down their capital stocks. However, certain restrictions on the underlying technology of production and consumer tastes can ensure that the steady state level of saving corresponds to the Golden Rule savings rate of the Solow growth model and thus guarantee intertemporal efficiency. Along the same lines, most empirical research on the subject has noted that oversaving does not seem to be a major problem in the real world.
A third fundamental contribution of OLG models is that they justify existence of money as a medium of exchange. A system of expectations exists as an equilibrium in which each new young generation accepts money from the previous old generation in exchange for consumption. They do this because they expect to be able to use that money to purchase consumption when they are the old generation.
Unlike the Ramsey–Cass–Koopmans model the steady state level of capital need not be unique. Moreover, as demonstrated by Diamond (1965), the steady-state level of the capital labor ratio need not be efficient which is termed as "dynamic inefficiency".
Diamond OLG Model
The economy has the following characteristics:
- Two generations are alive at any point in time, the young (age 1) and old (age 2).
- The size of the young generation in period t is given by Nt = N0 Et.
- Households work only in the first period of their life and earn Y1,t income. They earn no income in the second period of their life (Y2,t+1 = 0)
- They consume part of their first period income and save the rest to finance their consumption when old.
- At the end of period t, the assets of the young are the source of the capital used for aggregate production in period t+1.So Kt+1 = Nt,a1,t where a1,t is the assets per young household after their consumption in period 1. In addition to this there is no depreciation.
- The old in period t own the entire capital stock and consume it entirely, so dissaving by the old in period t is given by Nt-1,a1,t-1 = Kt.
- Labor and capital markets are perfectly competitive and the aggregate production technology is CRS, Y = F(K,L).
In Diamond's version of the model, individuals tend to save more than is socially optimal, leading to dynamic inefficiency. Subsequent work has investigated whether dynamic inefficiency is a characteristic in some economies and whether government programs to transfer wealth from young to poor do reduce dynamic inefficiency.
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