The past five decades have brought notable transformations within the Japanese economy. One distinctly visible change has been a rapidly aging workforce, which has affected consumption growth and ultimately precipitated a drop in interest rates. The decline has been significant. Japan's real interest rate (measured as the rate on risk-free government securities minus the inflation rate) declined from an average of 4 percent in the 1980s to an average of 2.3 percent in the 1990s, sliding further to an average of 1.7 percent in the 2000s.

In their paper, "Aging and the Real Interest Rate in Japan: A Labor Market Channel," Shigeru Fujita of the Federal Reserve Bank of Philadelphia and Ippei Fujiwara of Keio University and Australian National University set out to investigate the effects of aging on the behavior of the Japanese economy. Their paper asks questions that include: How much of the variation in consumption growth and interest rates can be explained by demographic shifts within the labor force? More directly, is the consistently low real interest rate in Japan related to the structure of the labor market?

To answer these questions, Fujita and Fujiwara begin by isolating what they believe to be the key precipitating factor in Japan's slowing economy: the end of the 1950s baby boom, which led to a sharp drop in worker entry into the labor force in the early 1970s. This dearth of younger workers set in motion structural changes that slowly — but persistently — changed the contours of the Japanese economy. By the 2000s, their analysis shows, labor-market contraction was associated with slower production growth and lower interest rates.

To provide a sharper view of how these outcomes transpired, the authors designed a unique quantitative model that illustrates the course of the Japanese economy as the makeup of the labor force slowly slants older beginning in the 1970s and continuing through the 1980s, 1990s, and 2000s. All along, their model captures how changes in demographics induced a gradual decrease in the real interest rate, revealing a causal link between the two. Their results indicate that roughly 40 percent of the fall in interest rates is attributable to aging within the labor force.

But what is the actual chain of events that provokes lower rates? What mechanisms are at work?

Their model shows that over time, slower labor productivity growth is a particularly important link in the chain, and it is followed by several unambiguous developments that eventually bring about lower rates.1 The slowdown of labor productivity growth, the authors note, is due to the shrinking share of younger workers entering the labor force and the increasing share of more-experienced older workers. This demographic shift in itself creates downward pressure on labor productivity growth because even though older workers are more experienced and thus more productive, their contribution to growth is limited, while the opposite holds for young and inexperienced workers.

In addition to the composition effect, Fujita and Fujiwara incorporate into their model a prominent feature of the Japanese labor market that has played an important role in the slowdown of productivity growth: Workers are valued primarily by their long-term service at a given employer. Put another way, workers are valued according to their firm-specific skills. The importance of firm-specific skills, in turn, implies that workers may find themselves in difficult situations if they lose their jobs after long tenures at their employers. When they seek new jobs, these workers may find that their skills/experiences are no longer valued by prospective employers. And because of this, they may be more likely to end up in low-wage, entry-level jobs. The aging workforce described earlier implies that more and more workers face this risk, especially when the risk of job loss increases, as it did when the Japanese economy slowed down in the 1990s. This interaction between the nature of human capital formation and the aging workforce has further exacerbated the slowdown of productivity growth in Japan. Fujita and Fujiwara highlight that during the period observed in their model, the firm-specific nature of human capital formation made the Japanese economy particularly vulnerable to changes in the economic environment, such as an aging workforce, because it hindered the portability of skills between jobs.

Aside from focusing on aging, Fujita and Fujiwara look at several other ways in which the Japanese economy has changed over time, and they accommodate these changes in an extension of their model. These long-run developments include, for instance, substantial increases in the number of females in the labor force (climbing from around 50 percent of the labor force in the 1950s to more than 70 percent in recent years) and increases in the share of workers on temporary contracts. The authors note that when such developments are included in their analysis, they only strengthen the overall economic effects of an aging workforce.

By designing a quantitative model that incorporates the shifts in demographic structure and the firm-specific nature of human capital, "Aging and the Real Interest Rate in Japan: A Labor Market Channel" reveals that an aging labor force contributes meaningfully to the decline in the real interest rates observed in Japan. More broadly, their evidence of a novel causal link between the aging of the workforce and falling interest rates contributes to a better understanding of the relationship between demographic change and broader economic trends. Fujita and Fujiwara explain the sequence of events at the core of this relationship, identifying the key variables and how they interact over time.

  1. Researchers have long sought to map the effects of aging on the broader economy. Previous studies have focused on a range of variables and interactions, but none of the existing literature has focused on the productivity channel explored in this study.