Towards a quantitative theory of automatic stabilizers: the role of demographics

Employment volatility is larger for young and old workers than for prime aged. At the same time, in economies with high tax rates, the share of total hours supplied by the young/old workers is smaller. These two observations imply a negative correlation between government size (measured by the share of taxes in total output) and aggregate output volatility. This paper assesses in a calibrated heterogenous agent, overlapping generations model the quantitative importance of these two facts to account for the empirical relation between government size and macroeconomic stability. The baseline calibration accounts correctly for the quantitative relation between output volatility and government size observed in the data.