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

This paper explores a causal link between the 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 skill levels. 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 driven by the drop 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 rule follows the standard Taylor rule, failing to recognize the time-varying nature of the natural rate of interest. The model suggests that the aging of the labor force accounts for roughly 40% of the decline in the real interest rate observed between the 1980s and 2000s in Japan.