How Will Population Aging Affect the Economy?

By Damon Gacicia

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Masson and Tryon’s "Macroeconomic Effects of Projected Aging in Industrial Countries" (1990) and Johnson and Falkingham’s "Aging and the Macroeconomy" (1992) both examine the effects the aging population of industrialized countries will have on the overall marco-economy. Their research focuses on the industrialized countries known as the Group of Seven, which includes the United States, Japan, Germany, France, Italy, United Kingdom, and Canada. High birth rates following World War II created an increase in the population. This large cohort, known as the "baby boom" generation, has moved through the age structure and is now nearing retirement. As they begin to retire, there will be an increase in the age of the population. By 2025, most of the "baby boom" generation will be retired, which has raised concern about the future of the economy. Now, most of the "baby boom" generation is in their late thirties and forties and still working. The main concern for the economy lies in consumption and production as this generation begins to retire. With an aging population, there will be a change in the economy due the number of dependents relative to the number that are employed, which is called the dependency ratio. The increased number of elderly will cause the dependency ratio to rise, which will affect the economy through consumption, production, saving rates and investment, and government expenditures.

The dependency ratio measures the number of dependents relative to the number employed. Those characterized as dependents are the young and the elderly. While the dependency ratio of youths remains constant or decreases in countries, the dependency ratio of elderly will certainly begin to increase over the next three decades as the "baby boom" generation moves through the age structure and begins to retire. Therefore, the combined dependency ratio should increase in most countries mainly due to the increase in the number of elderly. It is projected that by 2025 the elderly dependency ratio will rise in all countries, except Japan, due to the decline in the number of employed compared to the number that depend on them. However, by 2010 the dependency ratio will remain relatively constant. There are important implications that come with a rising elderly dependency ratio and a constant or falling youth dependency ratio. First, there will be an increase in government expenditures on medical care created by an increase in the elderly population. Second, due to the increase in the elderly population there will be increased spending on pension plans. Thirdly, due to the decreasing or constant dependency ratio of youths there is likely to be less spending on education. Finally, there are other implications that can be drawn from the dependency ratio, which include changes in consumption habits, production especially looking at the labor force, government expenditures, and the saving rate and investment.

The increase in consumption caused by an aging population will require many producers to change their production schemes to fit the needs of the demand of the elderly. The consumer boom of 1980 was driven by the "baby boom" generation. The size of the "baby boom" cohort dominated the market because producing for this generation, which was so large, would create greater returns for suppliers. Therefore, it is safe to assume that producers will change their products to fit the new consumption patterns of this cohort as it moves into old age. Many believe that consumption in domestic help will increase while there will be a decrease in spending on education. Another area of the market that will be affected by an aging population will be the housing market. The effects on this market could vary with the opportunity for more single people looking for houses due to the rise in divorce rates. However, if divorce rates were held constant the overall demand in the housing market would most likely decrease because the children of the "baby boomers", which represent a smaller cohort, will not demand as many houses.

The theory of human capital shows the earnings of different workers in the labor force. The wage of each worker is determined by the value of each worker’s labor to total production. The age of the worker plays an important role in determining the workers wage. Typically, the older worker receives a higher wage due to expertise and experience while the younger worker normally is underpaid in comparison to his or her value to total output. If older workers were more efficient than with the aging population, there would be a time of increase in labor productivity, which would have positive effects on the economy. Another theory is that younger workers are better technologically trained. Since the number of younger workers is smaller than older workers, it would be safe to assume that the work force would be technologically inefficient. However, neither of these two studies is very reliable. When looking at actual work place environments it was found that older workers were just as capable to learn new skills. Therefore, in some cases it would be cheaper to retain older workers than train younger workers the entire job. In the labor force, it is important to remember that part of older workers’ income goes to their retirement so their income growth rate can be very important. Therefore, many workers would object to a change in age-earnings profile, which is just simply an increase of income with age, because it would affect their pension plan. The final conclusion is that there should be an increase in the cost of labor due to the changing labor force and a highly competitive labor market between young and old workers.

The next important factor to look at is private savings and how it relates to the real interest rate and investment. The private savings rate certainly relates to consumption since everything that is not consumed will be saved. The life cycle model of savings says that when a person is younger he or she will save more for retirement. The model also suggests that as a person retires his or her savings will drop because they no longer have any income to save therefore they must consume from their previous savings. The general feeling is that the savings rate for the Group of Seven countries will fall as a result of an aging population. However, there is much debate over whether the savings rate will actually decline as the population ages. One reason is that by 2025 there is uncertainty whether the "baby boom" will have the same tendency to save. In old age consumption per person decreases so many may decide to save out of their pension, which would lead to an increase in the savings rate. It is hard to make any clear assessment of the savings rate and the rate of growth especially with technological progress and investment as uncertain as they are for the next few decades. In general, as the population ages the savings rate should fall which will lead to a reduction in the real rate of interest, which will cause increased investment. The increase in investment will make the size of the capital stock bigger and stimulate the economy.

The increase in the dependency ratio of the elderly and decrease in the youth dependency ratio, will effect government spending on medical care, pension benefits, and education. As more people move to old age, there will be an increasing demand for medical care needs. The government will have to increase its spending on medical care and increase payments on pension benefits. The other shift in government expenditure will occur due to a falling youth dependency ratio. As the number of youths decrease there will be less government spending on education. The results of government expenditure are different in all the countries. For most countries, the government expenditure is falling, which causes a reduction in domestic demand. In both Germany and Japan, an increase in government expenditure causes an increase in total output. However, for the other countries output levels are falling.

The overall effect of an aging population on the economy cannot be determined with great certainty. Many factors, however, can be used to assess the overall status of the economy. These factors include consumption, production, savings rates, and government expenditures. Generally, consumption should increase, which will create an excess demand on certain goods. Second, production will decrease as the number of people in the labor force begins to decline. Thirdly, government expenditure on medical care and pension benefits should increase while spending on education will decrease. The savings rate should also fall as the population begins to age. The overall state of the economy by 2025 cannot be predicted with absolute certainty due to the number of demographic and technological factors that could change overall consumption and production in all of these countries. The factors above can give a general sense of what the economy may be like but with absolutely no certainty.

1 Paul Johnson and Jane Falkingham, "Aging and the Macroeconomy" in Ageing and Economic Welfare, Sage Publications, Newberry Park, California, 1992, Ch. 6, pp.152-176.

2 Paul R. Masson and Ralph W. Tryon, "Macroeconomic Effects of Projected Population Aging in Industrial Countries", IMF Staff Papers, Vol. 37, No. 3, September 1990, pp. 453-485.