In discussing the life-cycle model, we focused on the individual-choice problem without taking into account the interaction between households, the production sector of the economy, and the government. In this chapter we take a broader perspective and embed the life-cycle model into a general equilibrium framework. In this framework, prices adjust in order to balance supply and demand in goods and factor markets and the government has to operate under some balanced-budget rules.As in the previous chapter, individuals save in order to smooth consumption over the life cycle. However now, individual savings behaviour endogenously determines the capital stock. This is the central difference from the static general equilibrium model discussed in Chapter 3. Since in our equilibrium framework we have to distinguish households within a given period according to their age or birth year, the models we study are called overlapping generations (OLG) models. In this chapter we introduce the most basic version of the OLG model and discuss the computation of a transition path and the intergenerational welfare effects of policy reforms. In Chapter 7 we extend this baseline model version in various directions. This subsection sketches the economic environment used in this chapter and Chapter 7. We describe the lifetime of people who inhabit the economy as well as their consumption decisions. Then we move on to the production side and the government structure. Finally, the equilibrium conditions for goods and factor markets which close the model are derived. Demographics As in Chapter 5 we assume that households in the model live for three periods. For simplicity we do not account for income and lifespan uncertainty. However, now in each successive period t a new cohort is born, where the number of households Nt in this cohort grows at a rate np,t, i.e. Nt = (1 + np,t)Nt−1. From Figure 6.1 one can understand why this demographic structure is called ‘overlapping generations’. In each period t a cohort Nt is born, but this ‘new’ cohort overlaps with the two cohorts Nt−1 and Nt−2 born in the previous two periods.
The impact of green preferences on the relevance of history versus expectations