Demographics and asset prices

During the 20th century, the U.S. experienced a cyclical birth rate: 52 million people were born between 1925 and 1944, 79 million between 1945 and 1964, and 69 million between 1965 and 1984. These births influenced the behavior of the adult-to-youth ratio (AJ ratio). This paper examines the effects of demographic change—measured by the AY ratio—on the price-to-earnings ratio (P/E ratio) and the real interest rate in the postwar period. We construct an overlapping generations model with pure exchange in which changes in the AY ratio give rise to exogenous cycles. On the one hand, the model predicts that the P/E ratio should be in phase with the AY ratio. On the other hand, since the interest rate adjusts to prevent arbitrage opportunities, the model also predicts that the real interest rate should move inversely with the A/Y ratio, except after the A/Y ratio reaches its peak. Finally, the introduction of altruism and consumption habits helps improve the quantitative predictions of the original model with pure demographic effects. (Audio: Department of Economic Publications)