ERC Starting Grant SOLG for Policy

The Old, the Young, and the Uncertain Future: Using High-Dimensional Stochastic Overlapping-Generations Models to Evaluate Fiscal Policies that Shift Risk and Resources Across Generations

Governments spend enormous resources on policies that affect generations very differently, for instance related to education, infrastructure, or pensions. Moreover, financing of these measures is carried out through means, namely various forms of taxation and government debt, that also have a differential impact on people of different age. Policy choices along those two dimensions thus amount to potentially large transfers across generations. Furthermore, the costs and benefits of these policies, occurring over decades, come with large uncertainty related to, among other aspects, the prospects for productivity growth, for global financial conditions, and also for demographics itself. Due to the presence of these risks and their impact on fiscal transfers, fiscal policies constitute huge, often inefficient, intergenerational risk-sharing schemes.

To assess the welfare impact of such policies, one thus needs to model both the demographic structure of the population as well as the major risks that society faces. Careful modelling of risks is even more important as welfare implications of fiscal policies heavily depend on the risk-premia that lower government borrowing costs relative to the expected return on investments. A model can only properly capture these risk-premia – the excess return of risky assets over risk-free ones – if it includes the risks they derive from and the risk-aversion of households who evaluate them. It is the aim of SOLG for Policy to build stochastic overlapping generations (SOLG) models that integrate all these crucial elements and are thus able to quantitatively assess the welfare implications of fiscal policy choices involving redistribution and risk-sharing between generations. The main challenge for doing so – and thereby going beyond the current state of the literature – is to advance solution methods for solving the resulting high-dimensional SOLG models. Further challenges are the evaluation of welfare in SOLG models and the careful construction and calibration of such complex SOLG models for specific applications. The main objectives of SOLG for Policy are thus as follows:

  • Develop solution methods for SOLG models based on Adaptive Sparse Grids

  • Establish a comprehensive framework for welfare evaluation in SOLG models

  • Evaluate government debt policies when interest rates are low and uncertainty is high

  • Evaluate intergenerational transfers and risk-sharing through pensions