The past 30 years has witnessed a worldwide decrease in real interest rates. We demonstrate that a large part of the fall in interest rates can be explained by changes in demography, which are as the result of a sudden fall in fertility rates across all of the advanced economies in the early 1970s.
In the long run this leads to a lower population growth rate. In the short run the cohort born just before the fertility shock is disproportionally larger than the cohorts born before and after. As this large cohort accumulates assets for retirement, their savings flood the capital market leading to a collapse in its return and hence a collapse in interest rates. Our model predicts that real interest rates will continue to fall, overshooting the new balanced growth path level, until hitting a trough around the year 2035.
