What Students Should Know About How An Aging Population Impact the Economy

The process of population aging is accelerating worldwide. In Japan, the population has been shrinking over the past five years, the ratio of older people to working-age people is the highest in the world, and the median age is almost 47 years old. Across Europe, fertility rates have been below the replacement level for some time. In China, the growth rate of the working-age population has slowed since the late 1980s, and partly because of its previous one-child policy, China’s population is also rapidly aging. The median age in China has increased from around 19 years in 1970 to 37 years in 2015.

On the other hand, many low- and middle-income countries are at a considerably earlier phase in the demographic transition, with young and faster growing populations, and rising labour force participation rates. In India, the median age is around 27 years and the annualized growth rate of the population from 2010 to 2015 has been 1.2 percent. The U.N. projects that, in seven years, the population of India will surpass that of China, currently, the most populous country, and that India’s population will continue to grow through 2050. Much of the increase in world population between now and 2050 is projected to be in Africa, where fertility rates remain high.

The implications of these global demographic patterns on the economy are worth considering because they pose some challenges for policymakers. Indeed, the magnitude of the effects will depend on policy responses.

In this blog, I will discuss some of the ways these changing demographics could influence economic growth. Then I will turn to considerations for monetary, fiscal, and other government policies.

Demographic Implications for Economic Growth

The expected slowdown in population growth and labor force participation rates will have implications for long-run economic growth and the composition of growth. The key determinants of the economy’s longer-run growth rate are labor force growth and structural productivity growth — how effectively the economy combines its labor and capital inputs to create output. Demographics suggest that labor force growth will be considerably slower than it has been in recent decades, and this will weigh on long-run economic growth.

The aging of the population may also have a negative effect on structural productivity growth. Over the past five years, labor productivity, measured by output per hour worked in the non-farm business sector, has grown at an annual rate of only about a half of a percent; over the entire expansion, it has averaged 1 percent. At the same time, lower labor mobility means workers may remain in jobs that are not the best match to their skill sets. This would be a negative for productivity growth. Research also indicates that an individual’s innovative activity and scientific output peaks between the ages of 30 and 40, although that age profile has been shifting older over time.

The demographics-induced slower growth of the labor force and the possible dampening effect on productivity growth suggest that longer-run output growth will likely remain below the 3 percent rate seen over the 1980s and 1990s, unless there is some effective countervailing policy response.

In addition to affecting the economy’s trend growth rate, demographics will likely affect the composition of growth by shaping aggregate consumption, saving, and investment decisions. Increased longevity means that people will need to save more over their working life to fund a longer retirement period. This is especially true given the degree of under funding of public pension plans at the state and federal levels. Demand for healthcare will continue to rise, and an aging population will place different demands on the housing sector than a younger population, affecting the demand for single- versus multi-family properties, for owning versus renting, and for residential improvements that allow older adults to age in place. By affecting the composition of output, changes in the age distribution have the potential to affect the business cycle. Because of its cyclical and structural implications, demographic change also has implications for monetary policy.

Demographic Implications for Monetary Policy

Older people tend to hold more assets than the young and tend to be creditors while drawing down their assets to fund their consumption during retirement. Younger people tend to be borrowers but face tighter credit constraints than the old because they hold fewer assets. As the share of the population shifts from young to old, the propagation of an interest rate change through the economy is likely to change. There will be a smaller share of young borrowers able to take advantage of a decrease in interest rates but a larger share of older people who benefit from higher asset prices. This means that the use of interest rates as a monetary tool to stimulate the economy will be less effective as the population age. The ineffectiveness of interest rates to stimulate the economy is now very apparent in many developed countries such as Japan and some European countries with aging population where interest rates and growth rates are at historical lows or even negative.

Ultimately, how demographics affect economic outcomes will also depend on how governments respond fiscally.

Demographic Implications for Fiscal and Other Government Policies

The rising share of older people will put significant pressure on social security and other old-age related welfare benefits, with current workers providing support for current retirees. Countries’ government pension and healthcare funds will also be stressed. Projected longer-run fiscal imbalances are unlikely to be sustainable, and it seems likely that governments will need to respond with some combination of increased borrowing, reduced benefits, increased taxes, program restructuring, and policies intended to stem the growth rate of healthcare costs. Longer-run fiscal sustainability will depend on what combination is used, and how effective the actions are.

If financing the fiscal imbalances through increased government borrowing is undesirable, raising taxes and reducing benefits or other expenditures are not very appealing either. Depending on how such policies are implemented, they could ultimately hurt the economy’s longer-run growth prospects, leaving the fiscal outlook even worse. Moreover, in a world where counter cyclical fiscal policy is constrained, business cycle volatility could rise, and monetary policy could find itself near the zero lower bound more often, potentially requiring the use of nontraditional policy tools such as asset purchases and forward guidance in order to meet monetary policymakers’ economic objectives.

More effective policies to overcome the effects of the aging population on fiscal imbalances would focus on reducing the rising costs of healthcare, not just on health insurance. In addition, policies that increase the growth and productivity of the workforce would address not only fiscal imbalances but the downward pressure on longer-run growth from demographics or other sources. Policies that increase immigration, not reduce it, that support continuing education, that encourage R&D and innovation, and that provide incentives so people work longer should receive attention.