Modeling an immigration shock

•We study an OLG economy with production, affected by immigration shocks.•Immigration shocks have both aggregate and distributional effects.•We characterize the equilibrium allocation with sequentially complete markets.•With incomplete markets, linking public education and pensions achieves first best.•The model is used to understand capital flows in Spain during the period 1996-2008.

In this paper, we model an overlapping generation economy affected by an unexpected immigration shock and determine how households may insure themselves against “immigration risk”. We use the model to study the impact of immigration on (i) the welfare of different generations, (ii) the distribution of income among factors of production, and (iii) the optimal design of the intergenerational welfare state. In particular, we construct a system of public education and public pensions that mimics the efficient complete market allocation. We also consider the impact of immigration shocks in a small open economy. In this case, our model suggests that the external capital flow can act as a substitute for the missing private insurance markets. Our analysis delivers a set of predictions that we find useful for understanding certain aspects of the Spanish experience between 1996 and 2008.