Proceedings from the ECFIN Workshop "The budgetary implications of structural reforms" - Brussels, 2 December 2005

Since we allow the government to subsidise the PAYG pension system, the financing constraint is
given by the following equation

w_t^r part_t^r N_t^r = ssc_t w_t^e L_t + TRPEN _t                                         (30)

The left hand side gives current pension expenditures which are determined by the number of
persons older than 65 eligible for a pension. Eligibility criterion is past labour force participation
( part^r) and N_t^r is the total number of persons in retirement age. Pensions (w_t^r )are determined as a
percentage of current wages. Pensions are financed from two sources, social security contributions
of current workers plus government subsidies.

Lump sum transfers are adjusted proportionally to the gap between the debt to GDP ratio and its
target level b₀ according to the following rule

Δ T =-ψι(Yt- - bо) - ψ,( Yt- - Yt^-1- ).

Yt          Yt Yt -1

Equilibrium

There is a homogeneous good which is traded internationally, therefore world supply is equated to
world demand in each period and the market clearing condition is given by

55

∑Yit =∑(Cit+Iit+Git)                                                (32)

i=1            i=1

All bonds and equity supplied by the domestic government and the corporate sector are held by
domestic households. The market clearing condition for internationally traded bonds is

5

∑ Fit = 0 .                                                             (33)

i=1

Output price serves as numéraire. The competitive equilibrium of this economy consists of a
sequence of real interest rates (r_it) and allocations (C_it, I_it, G_it, K_it,F_it,Y_it) that satisfy the first
order conditions of households and firms, the budget constraints of households, governments and
firms and goods and bond market equilibrium conditions. Real wages (w_it) are determined by the
wage contracting rule (28) and firms set employment optimally according to the first order
condition (27). The labour market equilibrium can coexist with involuntary unemployment.
Furthermore, the evolution of the economy is subject to initial conditions
(K_i0, F_i0, Y_i0,Γ_i0, N_i^y₀, N_i^w₀, N_i^r₀) and a sequence of fiscal instruments (t_r, t_l, t_c, t_v b₀, g₀) as well
as a debt targeting rule that ensures intertemporal solvency of governments.

Because the initial position of the economy is far from the steady state, the solution of a model,
which is linearised around the steady state may give imprecise results. Therefore we have opted
for a solution procedure developed by Laffargue (1990), Boucekkine (1995) and Juillard (1996) to

78

<<   <   81   82   83   84   85   86   87   >   >>