Solving the Feldstein-Horioka Puzzle with Financial Frictions
Arizona State University (ASU) - Economics Department
University of Michigan at Ann Arbor
October 1, 2009
Unlike the prediction of a frictionless open economy model, long-term average savings and investment rates are highly correlated across countries - a puzzle first identified by Feldstein and Horioka (1980). We quantitatively investigate the impact of two types of financial frictions on this correlation. One is limited enforcement, where contracts are enforced by the threat of default penalties. The other is limited spanning, where the only asset available is noncontingent bonds. We find that the calibrated model with both frictions produces a savings-investment correlation and a volume of capital flows close to the data. To solve the puzzle, the limited enforcement friction needs low default penalties under which capital flows are much lower than those in the data, and the limited spanning friction needs to exogenously restrict capital flows to the observed level. When combined together, the two frictions interact to endogenously restrict capital flows and thereby solve the Feldstein-Horioka puzzle.
Number of Pages in PDF File: 31
Keywords: Feldstein-Horioka, savings, investment, financial frictions, limited enforcement, international capital flows
JEL Classification: F21, F34, F36, F41Accepted Paper Series
Date posted: December 18, 2009
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