A Simple General Equilibrium Lifecycle Model

Oksana Leukhina
April 2019

1 Environment
In this section we introduce a basic life-cycle model with perfect foresight. This is a 60-
period overlapping generations model. People are ex-ante identical, but at any given period
60 generations live together in the economy. Thus, people of the same age are identical,
but people of di¤erent cohorts (age) will di¤er in their capital accumulation, labor supply
and hours worked. Government decides on the retirement age and the retirement bene…ts,
similar to social security. These pensions are funded with taxes on current workers, i.e.
pay-as-you-go system. This is a general equilibrium model consisting of households, …rms
and government.
Households. Every year, a generation of equal measure is born. The total measure of
all generations is normalized to one. Households live T + T R = 40 + 20 years. The age of
a household is indexed by s = 1; :::; 60, and calendar year is indexed by t. For example, cst
is the consumption of household aged s at time t. The …rst 40 years are working years, and
after that retirement is mandatory. During retirement, households receive social security
bene…ts bt . There is no mortality before the age of 60, so the measure of each cohort is
(s) = 1=60 8s = 1; :::; T + T R . With the introduction of age-speci…c mortality, the measure
of each cohort in the population will be di¤erent. This model ignores childhood, so one can
think of it as a model of adult population (age 20).
The problem of a household who is born (age 1) in year t is
+T R
TX
s 1
max u cst+s 1 ; 1 hst+s 1
T +TR T
fcst+s 1 ;kt+s
s
gs=1 ; fhst+s 1 gs=1 s=1
s.t.
cst+s 1
s+1
+ kt+s = rt+s 1 kt+ss
1 + (1
s
) kt+s 1+
s
+i (1 t+s 1 ) wt+s 1 ht+s 1 + (1 i) bt+s 1 ,
kt1 = 0;

where i is an indicator that the person is of working age, i.e. i = 1 if s T and 0 otherwise.
Observe that initial capital is zero. This means people enter the model with no assets.
R
Individuals will not leave bequests, so k T +T +1 = 0. Also notice that labor supply decision
is only relevant for working households, and after retirement hst = 0. The next paragaph
can be skipped and you can just go to the optimality conditions for which you should have

1
good intuition. But for those of you who like the Lagrangian, the …rst order conditions are
derived as follows:
s 1
cst+s 1 : u1 cst+s 1 ; 1 hst+s 1 = t+s 1 , s = 1; :::; T + T R (1)
s+1 R
kt+s : t+s 1 = t+s (rt+s +1 ) , s = 1; :::; T + T (2)
s 1
hst+s 1 : u2 cst+s 1 ; 1 hst+s 1 = t+s 1 (1 t+s 1 ) wt+s 1 , s = 1; :::; T (3)

where ’s denote the Lagrange multipliers (one associated with each BC). Again notice
that the …rst order condition for the optimal labor supply is applies only to working age
households. For retired households, condition (3) doesn’t exist, because they are forced to
consume their entire time endowment as leisure.
Combining (1) and (3) gives the condition describing the intratemporal tradeo¤ – the
tradeo¤ between consumption and leisure –faced by households of working age:

u2 cst+s 1 ; 1 hst+s 1
[H2] : = (1 t+s 1 ) wt+s 1 , s = 1; :::; T:
u1 cst+s 1 ; 1 hst+s 1

The intuition is the same as what you saw for the Neoclassical Growth Model. The marginal
rate of substitution between consumption and leisure is given by their relative price (i.e. the
after tax wages).
Using (1) for two consecutive periods and combining with (2) gives the condition describ-
ing the intertemporal tradeo¤ (the Euler equation):

u1 cst+s 1 ; 1 hst+s 1
[H1] : = (rt+s + 1 ):
u1 cs+1
t+s ; 1 hs+1
t+s

The intuition is what you already know:.The marginal rate of substitution between apples
at age s 1 and applies at age s is given by the relative price of those apples. The right
hand side is the relative price of apples at age s 1 in terms of applies at age s –you give up
exactly rt+s + 1 units of apples at age s if you choose to eat one extra one at age s 1:
Also note we need to remember that hst+s 1 = 0 for s = T + 1; :::; T + T R 1. For example,
when s = T , i.e. the last period of work, H1 (the Euler equation) is

u1 cTt+s 1 ; 1 hTt+s 1
= (rt+s + 1 )
u1 cTt+s
+1
;1

and during retirement, i.e. when s = T + 1; :::; T + T R 1 = 41; :::; 59, H1 (the Euler
equation) simpli…es to
u1 cst+s 1 ; 1
= (rt+s + 1 ):
u1 cs+1
t+s ; 1

To summarize, the solution to the household problem is characterized by the following

2
system of equations:

u2 cst+s 1 ; 1 hst+s 1
[H2] : = (1 t+s 1 ) wt+s 1 , s = 1; :::; T
u1 cst+s 1 ; 1 hst+s 1
u1 cst+s 1 ; 1 hst+s 1
[H1] : = (rt+s + 1 ) , s = 1; :::; T + T R 1
u1 cs+1
t+s ; 1 hs+1
t+s
[BC] : cst+s 1 + kt+ss+1
= (rt+s 1 +1 s
) kt+s 1 + i (1 s
t+s 1 ) wt+s 1 ht+s 1 +
R
+ (1 i) bt+s 1 , s = 1; :::; T + T

Altogether we have T + T + T R 1 + T + T R = 40 + 59 + 60 = 159 equations. The

s
unknowns are hst+s 1 (T variables), kt+s 1 (T + T
R
1 variables because the initial capital is
R
given k = 0 and the …nal capital is determined by the non-bequest condition k T +T +1 = 0),
1

and cst+s 1 (T + T R variables). Thus, the number of unknowns is the same as the number
of equations. In order to solve this system of equations, we need to remember to plug in
R
k T +T +1 = 0 into the last budget constraint. Thus, the budget constraint for the last year
of life (i.e. the last equation no. 159), s = T + T R , is
R R
cTt+T
+T
+T R 1
T +T
= (1 + rt+T +T R 1 ) kt+T +T R 1
+ bt+T +T R 1 :

The household in the last year of life will consume his pension and all the capital stock
possessed in the beginning of that year.
Firms. There is one …rm that solves

max Yt rt K t wt Lt
Kt ;Lt
s.t.
Yt = F (Kt ; Lt )

where Kt is capital input and Lt is labor input. The …rst order conditions are

[F 1] : rt = F1 (Kt ; Lt )
[F 2] : wt = F2 (Kt ; Lt )

Government. We assume that government balances its budget in each period. The
revenue from workers of cohort s is t wt hst , so summing over all working cohorts, taking into
account the measure of each cohort, gives the total tax revenue:

X
T X
T
1
s
Revenuet = t wt ht (s) = t wt hst
s=1 s=1
T + TR

The spending on each retired household are bt , so the total expenditures are
+T R
TX
TR
Expenditurest = bt (s) = bt
s=T +1
T + TR

3
Balanced budget requires the two equal each other. Therefore, the government budget
constraint is given by

X
T
1 TR
[BCgov ] : t wt hst = b t
s=1
T + TR T + TR

Equilibrium. In equilibrium we will require that markets clear, that is, the aggregate
capital and labor employed by the …rm are equal to the total inputs supplied by households:
+T R
TX +T R
TX
1
Kt = kts (s) = kts
s=1 s=1
T + TR
X
T XT
1
Lt = hst (s) = hst
s=1 s=1
T + TR

The aggregate consumption is

+T R
TX +T R
TX
1
Ct = cst (s) = cst
s=1 s=1
T + TR

The law of motion of aggregate capital is the usual

Kt+1 = (1 ) Kt + It :

Notice that we assumed the government does not buy any output in this model. The
tax revenues from workers are transferred to the retired. Hence, the goods market clearing
is given by
Ct + It = Yt ;
which can be combined with the law of motion for capital and written in the following form:

Ct + Kt+1 = Yt + (1 ) Kt :

1.1 Computation of the Stationary Equilibrium

Suppose that At = A 8t, bt = b 8t. We are looking for an equilibrium characterized by
constant distribution across generations of consumption, labor supply and capital stock, and
constant wages and interest rates over time. So every cohort does exactly the same thing at
any given age. Thus, the index of the calendar year can be dropped. Let the period utility
be
1
s s [(cs + ) (1 hs ) ] 1
u (c ; 1 h ) = :
1
Let the production function be
Y = AK L1 :

4
With these functional forms, the equilibrium equations become:
(cs + )
[H2] : = (1 ) w, s = 1; :::; T
1 hs
(cs + ) (1 hs ) (1 )
[H1] : (1 )
= (1 + r) , s = 1; :::; T + T R 1
(cs+1 + ) (1 h ) s+1
s s+1
[BC] : c +k = (r + 1 ) k s + i (1 ) whs + (1 i) b, s = 1; :::; T + T R
[F1] : r = AK 1 L1
[F2] : w = (1 ) AK L
TR
[BCgov ] : wL = b
T + TR
TX+T R
1
MCK : K= ks
s=1
T + TR
X
T
1
L
MC : L= hs
s=1
T + TR

Note that because we are using the household BC as one of the equations, we do not
need to use the market clearing condition for the consumption good. It will be automatically
satis…ed.

The Solution Algorithm

Generally speaking, government policy should be speci…ed as the retirement bene…t
amount b and the labor tax rate : However, you can imagine that the equilibrium may
not exist for just any combination of these two values. For example, the government can
decide that it wants to charge zero tax and still pay a positive bene…t. Such policy cannot
be supported in equilibrium. Therefore, we actually need to look for goverment policy that
can be supported. So we think of setting and …nding b by solving BCgov , this can be done
as a part of procedure of solving for the model equilibrium.
So let me just count the number of equations and the number of unknowns. We already
counted that, for given model parameters ( ; ; ; ; A; ; ; T; TR ), government policy (b; )
and prices (r; w), the number of H1; H2 and BC conditions, T + T + T R 1 + T + T R ;
equals exactly the number of unknowns in the household problem fcs gTs=1 +TR
; fhs gTs=1 and
+T R
fks gTs=2 : There are …ve remaining equations: F 1, F 2, BCgov , MCK and MCL and also …ve
remaining unknowns: r; w; K; L and b:
Before we proceed to solve the model though, we want to make sure our statement of the
social security policy can match how it works in practice. Typically, social secruity policy
in terms of taxes and replacement ratios –the fraction of the average labor income that is
replaced by the retirement bene…t. Let’s de…ne the replacement ratio as
b
=
(1 ) wh
P
where h = Ts=1 hs T1 denotes the average labor supply. is something that we can measure
in the data, a given quantity which describes the social security policy. So we can restate

5
the bene…t in terms of the tax and replacement ratio:

[Benef it] : b = (1 ) wh

Substituting for b from the above expression into the goverment budget constraint gives

TR
wL = (1 ) wh ;
T + TR
! !
X
T
1 XT
TR
s 1
hs = (1 ) h ;
s=1
T + TR s=1
T T + TR
TR
= (1 ) ;
T
[ ] : = :
T =T R +

Therefore, we will take from the data. We set according to equation [ ] ; which is just
a rewritten BC of the government, and we …nd b according to equation [bene…t]: Mechanically
speaking, we have the same unknowns as before, but we have replaced [BC gov ] with equation
[bene…t]. We still have the same number of equations as the number of unknowns.

Homework Question
Suppose
1
s s [(cs + ) (1 hs ) ] 1
u (c ; 1 h) =
1
1
Y = AK L

Assume = 2; = 2; = 0:001; = :99; A = 1; = 0:3; = 0; T = 40; TR = 20; = 0:1:

(a) Solve the model under the assumption of a stationary equilibrium. Submit age pro…les
for consumption, labor supply, capital holdings and investment.

(b) Suppose that the e¢ ciency of labor supply depends on age, say z s = 2 s=40:
Therefore, when a person of age s supplies hs units of time, he/she supplies z s hs units of
e¤ective labor. Reinterpret L as the total units of e¤ective labor. So in equilibrium
P total
e¤ective labor demanded must equal total e¤ective labor supplied, i.e. L = Ts=1 z s hs . The
wage rate is again just the marginal product of L: The labor income at age s is then wz s hs .
Modify the codes and repeat part (a). How do your pro…les change? Explain the intuition.