Demographics and the natural interest rate in the euro area

We investigate the impact of demographics on the natural rate of interest (NRI) in the euro area, with a particular focus on the role played by economic openness, migrations and pension system design. To this end, we construct a life-cycle model and calibrate it to match the life-cycle profiles from HFCS data. We show that population aging contributes significantly to the decline in the NRI, explaining about two-thirds of its secular decline between 1985 and 2030. Openness to international capital flows has not been important in driving the EA real interest rate as aging in Europe has been similar to that in the rest of the world so far. Of two possible pension reforms, only an increase in the retirement age can revert the downward trend on the equilibrium interest rate while a fall in the replacement rate would make the decline in NRI even deeper. The demographic pressure on the Eurozone NRI can be alleviated by increased immigration, but only to a small extent and with a substantial lag.