Usefulness of the article: This article aims to shed light on the impact of demographic aging on inflation, as well as to summarize research and studies conducted on the subject. It shows by extension that the challenges associated with aging will have to be addressed in a world of low inflation and growth.
Summary:
- In the coming decades, developed countries will face massive population aging, with retirees eventually outnumbering the working population.
- While it is well established that these demographic shifts will have a negative impact on the macroeconomic performance of these countries, the consequences in terms of inflation are unclear.
- Economic theory offers multiple interpretations, with advocates of inflationary aging opposing critics of deflationary aging.
- The effect of an increase in the number of retirees on inflation is mediated by contradictory channels. Theoretical considerations alone do not allow us to settle, even provisionally, the question of the link between demographic change and price levels.
- In a second article, the diagnosis will be supplemented by a critique of inflationary theory and a review of empirical studies, the vast majority of which conclude that disinflationary forces outweigh inflationary pressures.
Raw material shortages and supply difficulties linked to a faster-than-expected recovery in the global economy, coupled with massive stimulus plans, particularly in the United States, are driving inflation to high levels. In September, the harmonized price index for the eurozone rose 3.4% year-on-year, its highest level in 10 years, while in the United States, inflation (at 5.4% in September) has been above 5% year-on-year since June. These inflationary pressures, although likely to be temporary due to their localized nature in certain sectors, particularly energy, have reignited the debate about the medium- to long-term inflation outlook for developed countries.
First, it should be remembered that questions about the future trend of inflation are extremely important for a number of reasons. If higher inflation were to become the norm in the future, we would likely see pressure on real interest rates, which would raise questions about the ability of developed economies to maintain sustainable levels of debt (both public and private). This would also be a source of financial instability, as market players currently have allocation strategies calibrated for persistently low interest rates.
Among the major determinants of future inflation, one is the subject of heated debate: demographic aging. While some economists see it as a factor contributing to global disinflation, others argue for a paradigm shift in which inflation would be very high once the elderly greatly outnumber the working-age population.
- Demographic aging: an immutable feature of developed economies
Over the past few decades, industrialized countries have undergone major demographic changes. Increased life expectancy coupled with declining fertility have been the main drivers of rapid population aging. Between 1950 and 2020, developed countries saw the median age of their populations rise from 29 to 40. This has resulted in a sharp increase in the old-age dependency ratio (the ratio of people aged 65 and over to those aged 15 to 64), which rose from 12% to 28% over the same period. And this process of demographic aging in developed countries is far from over. According to the latest United Nations population projections, the old-age dependency ratio is expected to reach 55% in 2100 (compared to an average of 38% for all countries worldwide).
Figure 1: Old-age dependency ratio (estimated and projected)
Source: OECD, BSI Economics calculations
This trend is leading to many changes in the structure of developed countries’ economies: a decline in the working-age population, changes in the composition of the workforce, and changes in consumer preferences. Beyond concerns about the sustainability of public pension systems and the financing of healthcare, this change in the age composition of the population also presents challenges in terms of macroeconomic performance.
While it is widely accepted that population aging is detrimental to economic growth, there is little empirical evidence on the magnitude of its effects (Maestas et al. 2016). The age composition of the population directly affects the supply of production factors in the economy. An older population is associated with a more capital-intensive and less labor-intensive economy, so aging directly affects production possibilities and factor returns. Maestas et al. (2016) quantify the loss of GDP linked to aging in the United States by comparing the macroeconomic performance of different US states with different demographic trajectories predetermined by fertility rates. They find that a 10% increase in the proportion of the population aged 60 and over reduces the growth rate of GDP per capita by 5.5%. Two-thirds of the GDP loss is due to slower labor productivity growth, while one-third is due to slower labor force growth. If this trend continues, the United States would see its potential growth slow by 1.2 percentage points during the current decade and by 0.6 percentage points in the next decade due to population aging.
In summary, Yoon et al. (2014) and Aksoy et al. (2019) show that population aging significantly influences most macroeconomic variables such as investment, savings, and interest rates.
Among the various impacts of demographic aging on macroeconomic variables, its impact on inflation is the most controversial.
- In theory, demographic aging can have both an upward and a downward effect on inflation.
The link between demographic aging and the general price level is so hotly debated because, from a theoretical point of view, the proportion of the elderly population can affect inflation in two opposite ways. It therefore depends on the quantification of these effects to determine whether the increase in the number of elderly people will be inflationary or deflationary.
Inflationary theories
Three main channels are mentioned in the literature to justify the positive relationship between the dependency ratio of people over 65 and inflation.
The first is based on a purely economic mechanism that can be summarized as follows: retirees are consumers who do not produce. As Juselius and Takáts (2015)[1] argue, the consumption of older people is not offset by any additional supply, and this excess demand pushes prices up. This inflationary pressure would be all the stronger as the decline in supply caused by the decline in the working-age population would not be offset by productivity gains. Juselius and Takáts (2018) complete their theoretical framework by mentioning « finding a robust relationship between demographic aging and inflation, which is consistent with the life cycle hypothesis. » The strength of this theory (Ando and Modigliani, 1963) is that it offers an explanation for age-related cycles of saving and dissaving. Individuals borrow when they are young, save during their working lives, and then consume these savings once they retire to support themselves.
The other two channels have been summarized and recently revisited with force by Goodhart and Pradhan (2020) in their book » The Great Demographic Reversal. » The first of these is the increase in the dependency ratio of the elderly, which will by definition reduce the working-age population and lead to labor shortages and an increase in the bargaining power of labor relative to capital. This would result in higher real wages and a shift in value added in favor of workers, thereby creating inflationary pressures. The final transmission mechanism would be through higher real interest rates, particularly at the long end of the sovereign bond yield curve. This would reflect a shift in the balance between savings and investment in national economies and the end of a global savings glut. Goodhart and Pradhan argue that demographic aging is a disruptive force that will reverse the current « megatrend » of low inflation and low inflation expectations.
Disinflationary theories
The inflationary thesis of demographic aging has been criticized, both theoretically and empirically, by numerous institutions (IMF 2012, 2013, 2014) and several central banks (starting in 2011 with Bank of Japan Governor Shirakawa) that argue that the increase in the dependency ratio will be accompanied by deflationary pressures.
Shirakawa (2011a, 2011b, 2012, and 2013) is the first to quantify the impact of aging on major macroeconomic aggregates and argues that the increase in the dependency ratio depresses consumption and investment due to weak demand from the elderly. This cannot be easily offset by monetary policy. He argues that population aging can lead to deflationary pressures by reducing expectations of future economic growth. These arguments are supported by the work of the IMF (Anderson et al. 2014; Yoon et al. 2014), which adds that aggregate demand would also be depressed by negative wealth effects resulting from falling asset prices on financial markets, since in a country with a declining population there are more sellers of securities (the elderly population sells assets to finance their retirement) than buyers (the working population buys securities to build up their wealth).
Beyond transmission through traditional economic channels, demographic aging would lead to a deterioration in the transmission of monetary policy due to less well-anchored inflation expectations( Imam 2013). Monetary tools, particularly unconventional ones, would be less effective in stimulating inflation and stabilizing it close to its target. Research by the European Central Bank shows that there is a positive long-term relationship between inflation and the growth rate of the working-age population as a proportion of the total population (Bobeica et al. 2017) and that » low birth rates and increased life expectancy significantly reduce the natural interest rate[4]. As a result, central banks are more likely to hit the lower bound of the nominal interest rate and face long periods of low inflation » (Bielecki et al. 2019).
Finally, there are political economy arguments suggesting that aging is deflationary. The growing weight of older people in the population increases their political power, as they campaign for low inflation due to its unfavorable distributional effects on their age cohort, maintaining a power structure that makes the fight against inflation a priority (Bullard et al. 2012).. This is particularly the case in Japan, where the population keeps the conservative party in power with a central bank (BoJ) that is among the most conservative, as measured by Levieuge and Lucotte (2014).
Conclusion
One of the major phenomena common to developed countries that will characterize mature economies in the coming decades is the significant increase in the average age of the population, resulting in a sharp increase in the proportion of retirees relative to the working-age population.
This change in the structure of advanced economies will be a major challenge for economic policymakers, as they will have to find ways to sustain public pension systems and healthcare financing in a macroeconomic environment that is also impacted by this transformation.
While there is little doubt that aging societies are associated with poorer macroeconomic performance, particularly in terms of per capita income growth, the effect on other variables such as inflation is the subject of much controversy. It is also necessary to understand how inflation will react to aging populations, as the implications for economic policy change dramatically depending on whether tomorrow’s world will be inflationary or disinflationary.
This first article presents the arguments and assumptions underlying the various theories that seek to explain the link between demographic aging and inflation. The ambiguity of the expected effects makes any conclusion based solely on theoretical elements inconsistent.
In an attempt to resolve this issue, with all the limitations that this implies, a second article will complete the diagnosis by offering a critique of inflationary theory and reviewing the empirical studies, the vast majority of which conclude that disinflationary forces outweigh inflationary pressures.
Bibliography:
Aksoy, Yunus, Henrique S. Basso, Ron P. Smith, and Tobias Grasl. 2019. « Demographic Structure and Macroeconomic Trends. » American Economic Journal: Macroeconomics, 11: 193-222.
Anderson, D, D Botman and B Hunt (2014) « Is Japan’s Population Aging Deflationary? » IMF Working Paper 14/139, August
Ando, A and F Modigliani (1963) “The ‘life cycle’ hypothesis of saving: aggregate implications and tests”, American Economic Review, vol 53 pp 55–84
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[1] Who were the first to model the impact of each age cohort on inflation for a panel of 22 advanced economies from 1870 to 2016
[2] The global excess of savings over investment is often referred to as the “global saving glut” phenomenon, highlighted in mid-2006 by the IMF and in 2007 by the OECD. Goodhart and Pradhan argue that the savings of retired households decline over time as they sell their assets to finance their consumption. A larger share of retirees in an economy would therefore imply, all other things being equal, that aggregate household savings would decline and put an end to the excess savings relative to investment that we see in our economies.
[3] The most detailed work on survey data shows that, all other things being equal, inflation expectations increase with age (Blanchflower and MacCoille, 2009), so as society ages, it becomes more difficult for central banks to keep households’ inflation expectations close to their target. This is consistent with the idea that aversion to inflation increases as a country’s population ages.
[4] These results support the idea that demographic aging has a negative impact on the natural interest rate: a previous article detailed the factors that influence the natural interest rate (available here).
