Motivation

Mortality decline & individual saving decisions: A simple model

Conclusions & Further Analysis

Economic Consequences of Demographic Changes: (2) On

Individual Saving Decisions

ECON2225 Economics of Population Changes (2019)

S. Paul Lau

Faculty of Business and Economics, University of Hong Kong

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

Outline

1 Motivation

2 Mortality decline & individual saving decisions: A simple model

3 Conclusions & Further Analysis

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

Study the e¤ects of demographic changes on di¤erent economic variables,

one at a time
First, focus on the e¤ect of mortality change on savings
A simple two-period model, holding other decisions (such as retirement)
exogenous (to be relaxed later)
Get familiar with the relevant demographic & economic concepts
The main message is easier to see in this simple context

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

Question to you:
Will you (assuming that you are an income earner now) respond to
expected mortality decline (i.e. a rise in life expectancy) by saving more or
less now? Why?
Without thinking for too long, what is your answer currently?

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

(Let’s see how economic models predict people’s behavior on average)

A two-period model with lifetime uncertainty
The individual lives the …rst period with certainty, but the individual will
survive to the second period with a probability p (0 < p < 1)
Behavioral assumptions:
(1) The individual supplies labor inelastically (i.e., no labor versus leisure
choice) in the …rst period, and then retires in the second period (if s/he
can survive to that period)
(2) Perfect annuity market: Will elaborate

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

De…nitions:
c1 = consumption level in the …rst period
c2 = consumption level in the second period
s = the saving level in the …rst period
w = the wage rate in the …rst period
Simplifying assumptions:
interest rate from the …rst to second period = 0
subjective discount rate = 0 (i.e., discount factor = 1)

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

The budget constraints corresponding to the …rst and second periods,

respectively, are given by
c1 + s = w (1)
&
1
s = c2 (2)
p
1
Why the term p appears in the budget constraint of the second period?
(Tutorial)

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

The problem:
The individual chooses c1 & c2 to maximize
" #
(c1 )1 θ 1 (c2 )1 θ 1
U= +p , (3)
1 θ 1 θ

subject to the two (‡ow) budget constraints above, which can be

combined to form the intertemporal budget constraint

w = c1 + s = c1 + pc2 (4)

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

Solution:
Form a Lagrangian
!
(c1 )1 θ 1 (c2 )1 θ 1
L= +p + λ (w c1 pc2 ) (5)
1 θ 1 θ

F.O.C.:
∂L θ
= 0 : (c1 ) λ=0 (6)
∂c1
∂L θ
= 0 : p (c2 ) pλ = 0 (7)
∂c2
Combining the 2 F.O.C., we have
θ θ
p (c2 ) p (c1 ) =0 (8)

leading to
c1 = c2 (9)
Note: * stands for optimal choice
Intuition of (9)? (Hint: the economic factors behind the Euler equation,
and ρ = r here)
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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

Substituting (9) into (4), we have

w = c1 + pc1

! (1 + p ) c1 = w
1
! c1 = w <w (10)
1+p
Therefore, the (positive) saving level in period 1 is

s =w c1

1
=w w
1+p
p
= w >0 (11)
1+p

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

What is the e¤ect of mortality decline (i.e., an increase in p in this model)

on the saving level in period 1?
e.g., p = 0.5
p 0.5
s = w = w =?
1+p 1 + 0.5
now p = 0.8
p 0.8
s = w = w =?
1+p 1 + 0.8

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

Analytically,
ds d p
= w
dp dp 1+p
d 1
= 1 w
dp 1+p
2
= ( 1 ) (1 + p ) w >0
ds
Intuition of > 0:dp
Since it is assumed that there is no choice in extending the working
duration (in this model), s/he has to save more during working to provide
the resources for consumption during the longer (expected) lifetime
Question:
Based on your observation, is “no change in working duration” a good
assumption?

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

Individual’s saving decision is likely to be a¤ected by, among others,

mortality decline
We use a simple 2-period model to study (some) rational factors in the
saving decision
Main result:
Individuals choose to save more to provide consumption for the longer
(expected) lifetime
(Further thought: Is this prediction consistent with the data? If not, why
and what modi…cations need to be made?)
More general lesson:
When we expect huge exogenous changes (e.g., mortality decline), we
respond by changing our behavior accordingly (perhaps in a rational way)

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 Motivation
Mortality decline & individual saving decisions: A simple model
Conclusions & Further Analysis

Aspects of the model to be improved:

(1) Other economic factors missing: retirement decision, . . .
(2) Two-period model is relatively simple to use in analyzing dynamic
issues, but a period in the model would correspond to 30 to 40 years. Not
so realistic for modelling actual life-cycle decisions.
(3) “probability p of surviving a duration of 30 to 40 years” may not be a
suitable way to model actual mortality change
(4) partial equilibrium analysis above
Need to be modi…ed.

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