Demographic Impacts on Life Cycle Portfolios and Financial Market Structures

This paper provides a framework to endogenize rates of return for risk-free bonds and
risky capital in an overlapping generation model. The rate of return on capital is
endogenized by introducing idiosyncratic production shocks to avoid computation
challenges associated with aggregate production shocks in the literature. The framework
enables the interaction between financial markets and macroeconomic conditions in a
production economy. Based on this framework, the paper first examines life-cycle
portfolio choice without demographic change, and illustrates that several factors such as
borrowing costs, labor income and production risk play important roles in life-cycle
portfolios. The paper then investigates the impacts of population aging on
macroeconomic conditions, life-cycle behaviors and financial market structures. The
results show that population aging leads to higher capital-labor ratios, and reduces the
rates of return on both assets. The bond market shrinks significantly, and capital
decreases if the fertility rate declines but increases if the mortality rate declines, leading
to structural change in financial markets. The impacts on life-cycle variables are quite
different in the fertility and mortality cases particularly at the late stage of life.