Declining Trends in the Real Interest Rate and Inflation: Role of Aging

This paper explores a causal link between aging of the labor force and declining trends in the real interest rate and inflation in Japan. We develop a New Keynesian search/matching model that features heterogeneities in age and firm-specific skills. Using the model, we examine the long-run implications of the sharp drop in labor force entry in the 1970s. We show that the changes in the demographic structure induce significant low-frequency movements in per-capita consumption growth and the real interest rate. They also lead to similar movements in the inflation rate when the monetary policy follows the standard Taylor rule, failing to recognize the timevarying nature of the natural rate of interest. The model suggests that aging of the labor force accounts for roughly 40% of the declines in the real interest rate observed between the 1980s and 2000s in Japan.