Are Macro Shocks Second Order?

Laurence Kotlikoff gratefully acknowledges research support for this study from the Sloan Foundation, the Goodman Institute, Boston University, Economic Security Planning, Inc., and the Federal Reserve Bank of Atlanta. Laurence Kotlikoff is President and principal shareholder of Economic Security Planning, Inc. The computation engine used in this study is based on Kotlikoff's company's MaxiFi Planner's computation engine. This said, there is no clear financial or commercial advantage to Kotlikoff from this pure research study.

This paper addresses two fundamental macroeconomics questions. First, are macro shocks large enough to alter the course of the economy? Second, are they large enough to materially impact economic welfare? Lucas and many others have addressed these issues, but do so primarily in the context of representative agent models. We study these questions using a large-scale, stochastic overlapping generations (OLG) model, i.e.~a real business cycle (RBC) in OLG model. We consider 80 generations overlapping in an economy buffeted by realistically calibrated total factor productivity (TFP) and capital depreciation shocks. The model is solved using Marcet's projection method taking explicit account of the full state space, which comprises 81 variables. Our findings, some recapitulated from prior studies by Hasanhodzic and Kotlikoff, suggest macro shocks are second order both with respect to their impact on aggregate variables and individual welfare. Specifically, the probability that the stochastic economy’s long-run aggregates materially deviate from their deterministic counterparts is less than one percent. Furthermore, the realized (simulated) lifetime utility of generations born in the long run rarely differs from deterministic long-run utility levels by more than one percent, measured as consumption-compensating differentials. These findings are supported by the model's small equity premium. Moreover, they are essentially indifferent to the presence of a bond market. Both results suggest agents are minimally concerned with precautionary savings against these shocks. Consequently, we argue that macroeconomics should shift its primary focus from short-term stabilization to intergenerational redistribution and other macroeconomic policies that demonstrably impact the long-run path of the economy and welfare. Thus, our paper focuses on the dog that didn't bark -- the failure of realistically calibrated shocks to materially matter in the long run notwithstanding significant observed financial-market reactions to short-term economic shocks.