12Financial Theory

12Financial Theory - Financial Theory

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Financial Theory: Lecture 12 Transcript October 13, 2009 << back Professor John Geanakoplos: All right, well, today I'm going to talk about Social Security again. There's going to be one more discussion of Social Security later. I'm going to defer most of my plan until later, but I want to finish the discussion so that we totally understand the subject. It'll also allow me talk about demography and introduce one of the most famous models in economics called the Overlapping Generation Model. So in the 1940s someone named Maurice Allais, a French economist, introduced the Overlapping Generations Model into economics. He wrote it in French and it was sort of rediscovered by Samuelson in the 1950s. I'm not sure whether Samuelson had read Allais. I think Samuelson may well have read Allais, but anyway Samuelson--so these were 1947, something like that, 1958 in which Samuelson rediscovered it. And you'll see it's a very basic thought and it seemed at first to challenge everything that we've learned so far. So the idea of the Overlapping Generations Model is that time doesn't have a beginning and an end like we've assumed so far, time might go on forever. Now, whether or not you believe time--whether there's scientific proof that time goes on forever or scientific proof that the universe has to come to an end, let's face it, many of our institutions presume that time goes on forever. The chief most important among them is Social Security which we'll see is the easiest thing to, the model's design to understand. The idea of Social Security is the pay as you go Social Security. The idea of Frances Perkins was that every young generation was going to give money to the old, but they shouldn't worry so much about it because when they got old the next young generation would give them money. Obviously if you thought time was going to come to an end the last young generation, knowing that they were the last generation, would refuse to give money to the old because they weren't going to get anything back when they were old. But then the second to last generation knowing that when they got old that they'd get nothing from the last generation's young they wouldn't give anything either to the old, and working backwards like that if everybody's rational and it's common knowledge that the world is going to end nobody would ever participate in the Social Security scheme. So it's clear that there's some thought that the world might end, or at least there's a thought that it's not worth bothering about the world ending. So the Overlapping Generations Model is meant to take that idea extremely seriously and imagine life going on forever. So let's take the simplest example where there's a generation that begins--generations last when they're young and old. So let's say we're at time 1 here, and there's a generation that's young and a generation that's old.
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12Financial Theory - Financial Theory

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