What is OLG model?

An overlapping generations model, abbreviated to OLG model, is a type of economic model in which agents live a finite length of time long enough to overlap with at least one period of another agent’s life. As it models explicitly the different periods of life, such as schooling, working or retirement periods, it is the natural framework to study the allocation of resources across the different generations.

Some of the features of OLG model.

One important aspect of the OLG model is that the steady state equilibrium need not be efficient, in contrast to general equilibrium models where the First Welfare Theorem guarantees Pareto efficiency. Because there are an infinite number of agents in the economy, the total value of resources is infinite, so Pareto improvements can be made by transferring resources from each young generation to the current old generation. Not every equilibrium is inefficient; the efficiency of an equilibrium is strongly linked to the interest rate and the Cass Criterion gives necessary and sufficient conditions for when an OLG competitive equilibrium allocation is inefficient.

Another attribute of OLG type models is that it is possible that ‘over saving’ can occur when capital accumulation is added to the model—a situation which could be improved upon by a social planner by forcing households to draw down their capital stocks. However, certain restrictions on the underlying technology of production and consumer tastes can ensure that the steady state level of saving corresponds to the Golden Rule savings rate of the Solow growth model and thus guarantee inter-temporal efficiency. Along the same lines, most empirical research on the subject has noted that over saving does not seem to be a major problem in the real world

A third fundamental contribution of OLG models is that they justify existence of money as a medium of exchange. A system of expectations exists as an equilibrium in which each new young generation accepts money from the previous old generation in exchange for consumption. They do this because they expect to be able to use that money to purchase consumption when they are the old generation.

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