The Feldstein-Horioka Puzzle and Spurious Ratio Correlation

Kam Hon Chu

Journal of International Money and Finance, 2012, vol. 31, issue 2, 292-309

Abstract: This study shows that the Feldstein-Horioka puzzle resembles a spurious ratio correlation due to a common deflator (Pearson 1896/7). Empirically, the Feldstein-Horioka specification and its counterpart with an arbitrary deflator – final domestic demand – give similar results. Monte Carlo results also indicates that the slope β and R2 of the ratio regression are upward biased. Theoretically, assuming each of the original undeflated variables are linear homogeneous functions of the deflator and random disturbances, formulas for β and R2 are derived. As saving and investment rates are numerically small relative to the disturbances, both β and R2 are predominantly determined by the disturbances and they tend towards unity when the disturbances are close in magnitude. The Feldstein-Horioka results are therefore noisy, though not entirely spurious, and do not necessarily reflect a strong correlation between investment and savings.

Keywords: Feldstein-Horioka puzzle; International Capital Mobility; Investment-saving correlation; Spurious Ratio Correlation (search for similar items in EconPapers)
JEL-codes: C2 E2 F3 F4 (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (14)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:31:y:2012:i:2:p:292-309

DOI: 10.1016/j.jimonfin.2011.11.015

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