Overlapping generations model
Based on de la Croix and Michel.
We have studied the Ramsey model, which predicts that the path derived from the competitive equilibrium is optimal. One of the main features of this model is that agents have an infinite horizon: they live forever and optimise considering an infinite horizon.
The overlapping generations model changes this hypothesis and focuses on the life-cycle: agents make decisions regarding how to consume, and how much to save for retirement. This is, the OLG model assumes that agents work until some age, and then retire.1 A focus of the OLG model is the intergenerational redistribution, allowing to study:
- social security,
- education policies and
- public debt.
The main departure with respect to the Ramsey model is that in OLG, agents are heterogeneous. Individuals live for two periods of time, and then die. In the first period, they are young and work. When old, they retire and live from savings. Hence, at any point in time, two types of agents with different budget constraints exist: young and adults.2
As we shall see, in this model the competitive path may not be optimal. Consequently, there may be instances in which the utility of all individuals can be increased. Therefore, the OLG model opens the door to government intervention, to reallocate consumption and savings efficiently. The OLG framework also permits the existence of bubbles and fluctuations.
A basic reference for this model is Diamond, (1965).