Ferrero, Gross and Neri (2019) established, using a reduced-form panel VAR for euro-area countries, that adverse demographic developments exert downward pressure on real interest rates and are projected to keep doing so. Their framework, however, identifies only the overall demographic effect: it cannot disentangle the transmission channels through which ageing operates (life-cycle saving, labor input, investment, output, inflation), cannot separate the macroeconomic effect of ageing itself from that of accompanying policy interventions such as later retirement, pension reform, migration, or participation policy, and relies on constant estimated coefficients in its counterfactual projections to 2025. The open problem is to credibly identify and quantify the transmission channels from population ageing to the equilibrium real interest rate and the linked macroeconomic aggregates, to separate the pure demographic effect from policy responses, and to establish how robust the demographic-interest-rate relationship is to time-varying structure such as shifting behavioral parameters and monetary regimes. Structural overlapping-generations studies have produced partial channel decompositions for Japan, the United States and the euro area, but recent robust-Bayesian work shows the magnitudes are poorly identified, the direction of the long-run effect remains contested, and no accepted decomposition exists.

Background

Nominal and real interest rates in advanced economies have declined steadily since the mid-1980s and reached historically low levels after the global financial crisis of 2007-2009. One prominent explanation is the secular stagnation view, associated with Hansen's 1930s idea and revived by Summers (2014), according to which structural forces — demographic change, slowing productivity growth, rising inequality, and a scarcity of safe assets — have pushed desired saving above desired investment, depressing the equilibrium or natural real interest rate for long periods. The natural (or equilibrium) real interest rate, often written r∗r^\ast, is the inflation-adjusted short rate that would prevail when the economy is at full employment with stable inflation; it is a key anchor for monetary policy because the effective lower bound (ELB) on nominal policy rates — the fact that central banks cannot cut nominal rates much below zero — binds exactly when r∗r^\ast is low. Population ageing is an especially consequential candidate driver because, unlike productivity growth, it is highly persistent and largely foreseeable: dependency ratios — the number of people of non-working age (0-14 and 65+) relative to those of working age (15-64) — are projected by institutions such as the European Commission to rise substantially in advanced economies.

Ferrero, Gross and Neri (2019, International Finance 22(3):262-278; DOI 10.1111/infi.12342) provided euro-area evidence on this link. They estimated a reduced-form dynamic panel vector autoregression (a panel VAR — a system of regressions of each macroeconomic variable on lagged values of all variables, estimated jointly across countries; their specification, a panel VARX, treats demographic variables as exogenous inputs) for euro-area countries over 1990-2015, with dependency ratios driving short- and long-term real interest rates, output, and inflation. They found that adverse demographic developments depressed euro-area real interest rates over the past decade, and their counterfactual projections — built on European Commission dependency-ratio projections to 2025 and holding the estimated coefficients constant — imply continued downward demographic pressure on real rates, with real short rates staying near zero and potential output growth falling from 0.8% to 0.5% by 2025 in their baseline scenario.

Reduced-form evidence of this kind identifies the total association between ageing and macroeconomic outcomes but not the mechanism. Economic theory suggests several distinct channels: longer life expectancy raises aggregate saving for retirement (a saving-supply channel that lowers the equilibrium rate); a shrinking workforce makes effective labor scarce relative to capital, raising capital intensity and lowering returns (a labor-scarcity channel); retirees run down wealth, which works in the opposite direction; ageing may also reduce investment demand, alter labor-market matching, and affect inflation through wage pressure and long-run monetary-fiscal interactions. Separately, ageing economies typically adjust policy — later retirement ages, pension reforms, migration, and measures to raise labor-force participation — and a reduced-form panel regression cannot tell how much of the estimated demographic effect is demography itself and how much is the policy response that accompanies it. Quantitative work using overlapping-generations (OLG) models — general-equilibrium models in which agents live for finitely many periods, so the age structure of the population matters — has begun to inspect these mechanisms: Carvalho, Ferrero and Nechio (2016, DOI 10.1016/j.euroecorev.2016.04.002) build a life-cycle model in which demographic trends between 1990 and 2014 reduced the equilibrium rate by about 1.5 percentage points; Eggertsson, Mehrotra and Robbins (2019, DOI 10.1257/mac.20170367) decompose the contributions of demographic and technological factors to the U.S. natural-rate decline since 1970 in a 56-period life-cycle model; Sudo and Takizuka (2020, DOI 10.1017/S1365100519000105) attribute 270 of the 640 basis-point decline in Japan's real rate over fifty years to demographic-driven declines in labor input and higher saving; and Papetti (2021, DOI 10.1016/j.jedc.2021.104209) quantifies for the euro area a demographic contribution of -1.7 to -0.4 percentage points to r∗r^\ast between 1990 and 2030 through a labor-scarcity channel and a saving channel, partly offset by retirement dissaving. Yet these structural estimates rest on calibrated or estimated parameters that recent robust-Bayesian analysis (Ho, 2024, DOI 10.1016/j.jedc.2023.104772) shows to be weakly identified without data on capital stocks and life-cycle consumption, and the sign of the long-run effect remains contested — Goodhart and Pradhan (2020, DOI 10.1007/978-3-030-42657-6) argue that ageing will ultimately prove inflationary and rate-raising. The unresolved question is thus not whether demographics matter, but through which quantitatively identified channels they matter, how their effect divides from that of the policy responses they trigger, and whether the relationship is stable across regimes and time.

Problem Statement

For advanced economies facing sustained population ageing (with the euro area, the setting of Ferrero, Gross and Neri 2019, as the reference case): identify and quantify the transmission channels through which demographic ageing affects the equilibrium real interest rate and the macroeconomic aggregates it moves — including aggregate saving, investment, effective labor input, output, and inflation; separate the effect of demographic change itself from the effect of policy interventions that accompany ageing, such as later retirement ages, pension reform, migration policy, and labor-force-participation measures; and establish how robust the demographic-interest-rate relationship is to time-varying structure such as shifting behavioral parameters and monetary regimes. All three components — the channel decomposition, the demography-versus-policy separation, and the robustness to time-varying structure — are required; the question is what the mechanisms and their quantitative magnitudes are, not merely whether the total effect is nonzero.

References

  1. Giuseppe Ferrero, Marco Gross, Stefano Neri (2019), 'On secular stagnation and low interest rates: Demography matters', International Finance 22(3):262-278. DOI: 10.1111/infi.12342. https://doi.org/10.1111/infi.12342
  2. Carlos Carvalho, Andrea Ferrero, Fernanda Nechio (2016), 'Demographics and real interest rates: Inspecting the mechanism', European Economic Review 88:208-226. DOI: 10.1016/j.euroecorev.2016.04.002. https://doi.org/10.1016/j.euroecorev.2016.04.002
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