Fertility, Capital Returns, and the Optimal Inflation Rate

If the fertilitarians (or, what should I call them? demographiles?) are right, their ideas have an interesting implication for monetary policy. If anticipated dependency ratios are necessarily to have dramatic effects on a society’s ability to support retirees, it must be the case that capital and labor are not very good substitutes. If capital could be easily substituted for labor, then a society could simply accumulate enough capital to replace the labor that won’t be available to support future retirees. If capital and labor are not very good substitutes, then the marginal product of capital will change significantly depending on how much labor is available to work that capital and how much capital has been accumulated relative to the available labor. Facing the prospect of a large capital stock (accumulated by those intent on retirement) and a small labor force (as growth of the working age population slows relative to the retired population), the expected marginal product of capital would decline. Classical economic theory tells us that the real interest rate should equal the marginal product of capital (less any applicable risk premium) in equilibrium. So, as a large cohort approaches retirement, the real interest rate should get very low. The real interest rate also tends to vary over the business cycle, becoming lower during times of economic weakness. If the fertilitarians are right, we can expect that the real interest rate will be low in general as a large cohort approaches retirement, and that that it will be particularly low – probably significantly negative – at business cycle lows that occur during that period. For the actual real interest rate to be negative, we need positive inflation. And the lower the equilibrium real interest rate is expected to be at its nadir, the higher an inflation rate we would need in order to actualize that low real interest rate. Thus, if you believe the fertilitarian argument, you should also believe that the optimum inflation rate is higher than it otherwise would be.