Simulation Analysis of The Alternative Life-Cycle Models

Abstract

<p>This thesis deals with the important issue of the elasticity of saving with respect to the interest rate. Michael Boskin, and more recently, Lawrence Summers, have argued that saving is much more interest-elastic than economists have generally believed, and as a consequence, that the dynamic efficiency losses from capital income taxation are much higher than they were previously thought to be. In Summers' life-cycle simulation model an increase in the interest rate depresses the present value of future labour income and this leads to declines in the consumption of younger cohorts, more saving, and a higher capital stock. These results are established with a CES utility function. I argue that it is reasonable to introduce minimum consumption levels into the model and that when this is done, younger cohorts do not decrease their consumption by as much in response to an interest rate increase. I show that the interest elasticity of saving is significantly reduced and may even be negative.</p> <p>In his analysis, Summers assumed an inelastic labour supply. I have relaxed this assumption by allowing both consumption and leisure to be decision variables of the individual. For a Cobb-Douglas utility function, I find the interest elasticity of saving to be 0.008, compared to 3.36 reported by Summers. Moreover, when a lower bound is imposed on consumption, the interest elasticity becomes negative.</p>