Multimod Mark III : The Core Dynamic and Steady State Model

Hamid Faruqee, Douglas Laxton, Bart Turtelboom, Peter Isard, and Eswar Prasad

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1998
• eBook ISBN: 9781557757227

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V Consumption and Saving Behavior: A Life-Cycle Perspective

As emphasized in the introduction of this paper, of MULTIMOD's most important functions is to assist with the IMF's multilateral surveillance over the policies of its members. Among other considerations, MULTIMOD has frequently been used to analyze the implications of changes in fiscal policies. In this context, it is now widely recognized that the analysis of fiscal policy in any macroeconometric model depends critically on the specification of consumption and saving behavior.

Following Keynes (1936), the view that changes in government deficits tended to have first-order effects on the level of economic activity became part of mainstream macroeconomic doctrine for several decades. However, the Keynesian framework was significantly challenged during the 1970s, partly in association with the rational expectations revolution, which generated a revival of the classical Ricardian view of government deficits.⁶⁹ From the Ricardian perspective, changes in government debt should have little or no real effects on economi activity, reflecting the view that forward-looking, rational agents would revise intertemporal consumption and saving decisions to offset the implications of changes in the intertemporal pattern of public sector consumption and saving behavior (that is, changes in government deficits).

Consistent with the rational expectations hypothesis that underlies the modern Ricardian view of fiscal policy, MULTIMOD assumes that economic agents behave in a forward-looking manner based on model-consistent (rational) expectations. It also recognizes, however, that the sensitivity of private saving behavior to a change in the public deficit depends importantly on factors other than the nature of expectations. In this context, MULTIMOD Mark III incorporates important changes (compared with Mark II) in the specification of consumption and saving behavior, which now reflect an explicit life-cycle dimension. While retaining the basic framework of forward-looking optimizing behavior, the Mark III specification allows us to explore the implications of the life-cycle paradigm, as well as other relevant considerations such as liquidity constraints (capital market imperfections) for the effectiveness of fiscal policy.

This section describes the theoretical framework and empirical estimates that underlie the specification of life-cycle consumption and saving behavior in MULTIMOD Mark III. It also examines the macroeconomic implications of such behavior for closed and small open economies by comparing a neoclassical paradigm in which agents are characterized as disconnected generations with life-cycle features to a classical (Ricardian) paradigm that views agents as dynastic families. An analytical framework that nests these two alternative views is developed on the basis of an extended version of Blanchard's (1985) overlapping-agents model. From the neoclassical perspective,⁷⁰ the analysis shows that changes in public saving can have considerable effects on the level of national saving, with implications for interest rates and asset accumulation. To estimate the quantitative importance of these life-cycle considerations for the effects of deficit finance on real interest rates, the capital stock, and net foreign assets, the model is calibrated to actual age-earnings profiles.

In the presence of life-cycle saving behavior, the rate of saving may vary significantly over time and across individuals, depending on where agents are within their respective life cycles. Younger agents expecting a rising earnings profile may choose to borrow and consume against their permanent income, which may initially exceed current income. At middle age, agents enjoying a relatively higher level of earnings may choose to accumulate assets and save for their eventual retirement. Upon reaching retirement, individuals may tend to run down their assets (dissave) in order to maintain a given level of consumption in the face of declining labor income.

To add an empirical content to this life-cycle dimension of the analysis, the model first incorporates a general specification of the relationship between individual earnings profiles and age. In particular, disposable labor income is assumed to generally increase with age as a worker gains experience and seniority before earnings level off and eventually decline with retirement. To calibrate the model, the time profile of labor income is estimated using earnings and employment data across different age groups in the United States.⁷¹ Using the ensuing calibration, the parameters describing the behavior of aggregate consumption are estimated, and the dynamic effects of fiscal policy on interest rates and the accumulation of capital or net foreign assets in a life-cycle context can then be simulated.

In terms of their fiscal implications, life-cycle considerations tend to augment the real effects of government debt on the economy (see Faruqee, Laxton, and Symansky, 1997). With no altruistic link between generations, an increase in the fiscal deficit is not fully offset by an increase in private saving, as a share of the debt burden falls on future generations whose marginal propensities to save presently are zero. With life-cycle (eventually declining) earnings and retirement, agents further discount the impact of future tax liabilities from an increase in public debt since the prospective tax base increasingly shifts to future generations with higher taxable incomes.

In a primarily closed economy, the resultant upward pressure on interest rates from an increase in government debt tends to crowd out investment and retard the rate of capital accumulation. In a small open economy, the decline in domestic saving is manifested in a crowding out of net exports and a greater reliance on foreign borrowing. In either case, the increase in current consumption takes place at the expense of lower living standards in the future, whether through a lower level of the capital stock or higher foreign claims on future output.

These results are in sharp contrast to the classical Ricardian view of government deficits. From a Ricardian perspective, the economic consequences of public debt and deficits should be minimal. According to the government's own (intertemporal) budget constraint, deficit financing represents a change only in the timing of taxes, while the present value of taxes remains unaffected, given public expenditure. Thus, the future taxes implied by higher government debt negate the benefits of any current reduction in taxes, leaving consumer demand unchanged. In the case of higher government spending, the increased deficit implies an increase in the present value of tax liabilities, which would act to lower current consumption. In either case, an increase in the budget deficit should be met with an increase in private saving, offsetting or diminishing the effects of lower public saving on aggregate saving and the economy.

The disparate implications of budget deficits within the Ricardian and Neoclassical paradigms stem from their contrasting views of the intergenerational link between individuals. In contrast to the life-cycle view, the Ricardian approach views agents as dynastic families, where current generations are closely linked (through a bequest motive) to their descendants. With stronger in...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Preface
• I Introduction
• II The Philosophy and Basic Structure of Multimod
• III The Steady-State Analogue Model and Mark III Solution Methodology
• IV The Inflation-Unemployment Nexus
• V Consumption and Saving Behavior: A Life-Cycle Perspective
• VI Investment
• VII International Trade
• VIII Extensions of the Core Model
• References
• Boxes
• Footnotes