A General Equilibrium Model of Age-Specific Employment Policies∗

Many countries around the world are simultaneously experiencing an aging labor force, sharp reductions in the labor force participation rates of older workers, and high unemployment among younger workers. In response, some governments have encouraged early retirement by the elderly to free up jobs for the young, while others have adopted policies that promote old-age labor force participation. The primary goal of this paper is to draw some qualitative insights about these different policy responses within the context of a dynamic general equilibrium model. We develop a model of the labor market characterized by search and matching frictions and embed it into an overlappinggenerations framework. We explicitly introduce age-targeted labor market policies and endogenize labor force participation across all age groups. Our analysis reveals that the age composition of the labor force may cause an inefficient allocation of workers to jobs in the labor market thereby creating an efficiency-enhancing role for publicly-induced retirement. Interestingly, public pension programs may improve labor market welfare by “redistributing bargaining power” over the lifecycle. Our work suggests that recent policy initiatives aimed at reducing the work disincentives currently embedded in many public pension programs may further the income redistribution motive of social security, encourage labor market participation among the elderly, and increase total employment. Complete elimination of the earnings test may improve labor market welfare. ∗We thank Casey Mulligan for his encouragement and for many helpful discussions. We have also benefited from detailed comments by Todd Keister and Martin Schindler. We also acknowledge useful feedback from Satyajit Chatterjee, John Duffy, Aarti Singh, Chris Waller, Dave Wildasin, Randy Wright, and seminar participants at the University of Kentucky, Southern Methodist University, the Midwest Macro Meetings at Nashville, the Federal Reserve Bank of Cleveland Central Bank Institute Summer Program on Monetary Economics (August 2002), 2003 Winter Meetings of the Econometric Society in Washington, and the 2002 UT-ITAM conference. Zhuo Chen and Moohoun Song provided able research assistance. †Corresponding author: Robert R. Reed III, Department of Economics, Gatton College of Business and Economics, University of Kentucky, Lexington, KY 40506; Phone: (859) 257-5975; Fax: (859) 323-1920; email: [email protected]