How an Ageing Population Affects Economic Performance, and Policies to Mitigate It

Answer

Part (a)

An ageing population raises the old-age dependency ratio and shrinks the working-age population. Japan’s economic performance is judged against its macroeconomic objectives — sustained growth, low unemployment, price stability and a healthy external balance — together with the fiscal sustainability of its social spending. The effect on all of these is, on balance, adverse.

Lower potential growth. Japan’s working-age population (15–64) has declined since the late 1990s, shrinking the total labour force. A fall in the quantity — and, as experience is lost, the quality — of labour reduces the economy’s productive capacity, shifting LRAS leftward and lowering potential output.

Ageing and potential growth: a shrinking labour force shifts LRAS left from AS₀ to AS₁ (classical range), lowering full-employment output from Yf₀ to Yf₁ — a fall in potential growth.

Cost-push inflation. As the labour force contracts relative to demand for labour, nominal wages are bid up across labour markets. Rising unit labour costs raise firms’ costs of production, which they pass on as higher prices — generating cost-push inflation and threatening price stability.

Strain on fiscal sustainability. A growing cohort of retirees raises pension and healthcare expenditure while the shrinking workforce narrows the tax base. This strains the public finances and the social-security system, the challenge the preamble highlights.

A possible offset. Not every effect is negative. Longer working lives and successful R&D — automation and robotics that substitute for physical labour — could limit the workforce decline, raise labour productivity, and give Japan a comparative advantage in robotics design and manufacturing, raising future export earnings and supporting the balance of payments. But these depend on policy succeeding; absent that, the net effect of rapid ageing on Japan’s future economic performance is adverse.

Part (b)

The adverse effects stem from a shrinking labour force, weaker productivity growth and reduced potential growth. Policies fall into two families — those that raise the quantity of labour and those that raise its productivity. My thesis is that productivity-raising supply-side policy is the more durable remedy, but it is slow, so it must be combined with measures that expand labour supply in the near term; the best mix depends on Japan’s specific labour-market constraints.

Policies to raise the quantity of labour. Extending the retirement age — Japan raised the mandatory age to 70 in 2021, and could phase it higher or abolish it, as Australia, Canada, New Zealand and the United States have done — keeps experienced workers in employment, limiting the workforce decline.

Evaluation. Unless the seniority-based wage system is reformed, employers resist retaining older workers, who are expensive relative to their productivity; and Japan already has among the highest older-male participation rates in the OECD, leaving little room to expand there.

Raising female labour-force participation — better childcare provision, shorter and more flexible working hours, enforcement of family-leave law — lets women (re-)enter and stay in work.

Evaluation. This partially offsets the workforce decline and bolsters women’s incomes and pensions (relative poverty among Japan’s over-65s is high), aiding fiscal sustainability. But poor job quality and excessive hours undermine such reforms.

Policies to raise labour productivity. Interventionist supply-side policy — human-capital development, R&D subsidies and tax incentives, and support for automation — raises output per worker. Higher productivity lowers unit costs, shifting SRAS rightward to ease cost-push inflation, while expanding capacity shifts LRAS rightward to restore potential growth — directly countering the two main supply-side harms of ageing and supporting the standard of living.

Productivity-raising supply-side policy: human-capital and automation shift AS₀ to AS₁ (intermediate range), raising output from Y₀ to Y₁ and lowering the price level from P₀ to P₁ — restoring growth while easing cost-push inflation.

Evaluation. Supply-side policy is the only lever that addresses ageing’s structural damage, but its effects come with a long time lag and require willing take-up; it cannot relieve the immediate workforce shortfall.

Judgement. No single policy suffices. Quantity-raising measures act quickly but face diminishing returns in Japan — older-male participation is already high, and retirement-age extension stalls without wage reform — so their scope is limited. Productivity-raising supply-side policy is the durable fix because it simultaneously restores potential growth and contains cost-push inflation, but its slowness means it must be paired with the near-term levers of female participation and longer working lives. The most effective response is therefore a sequenced mix: expand labour supply now (female participation, phased retirement-age rises with wage-system reform) while investing in human capital and automation for the long run, with the precise weighting set by Japan’s binding constraints — chiefly the seniority wage system and the quality of available jobs.