Understanding the New Normal: The Role of Demographics

To support the economic recovery from the Great Recession, the Federal Reserve held the federal funds rate near zero for over seven years and acquired large holdings of longer-term securities. Despite these extraordinary measures, real GDP has grown at only a modest pace during the recovery. Meanwhile, long-term interest rates have declined whereas measures of longer-term inflation expectations have been relatively stable, resulting in lower real long-term interest rates, as shown in Figure 1. Some observers, such as Rogoff (2015), trace these developments to persistent, but ultimately transitory, debt deleveraging and borrowing headwinds in the wake of the global financial crisis.

Others, like Summers (2014) and Eggertsson and Mehrotra (2014), see these developments as symptomatic of “secular stagnation,” by which a confluence of changes in the structure or functioning of the economy is leading to weak GDP growth and low interest rates of an enduring rather than cyclical nature.1 Commentators and policymakers have described this combination of low growth and low interest rates as a “new normal” for the U.S. economy.2 This paper seeks to understand how much of the new normal can be explained by demographic factors in the United States. The United States, like other advanced economies, is undergoing a dramatic demographic transition related to the unfolding of the post-war baby boom.3 As a consequence, the growth rate of the labor force has declined and should remain low for the foreseeable future.

4 In this paper, we investigate the extent to which demographic changes, especially those related to the baby boom, can explain the currently low levels of real interest rates and GDP growth. We build an overlapping generation (OG) model that is consistent with observed and projected changes in fertility, labor supply, life expectancy, family composition, and international migration. The model allows us to explore the extent to which demographic changes, in and of themselves, can explain the timing and magnitude of movements in real interest rates and real GDP growth during the post-war period and beyond.

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