What is it about?
Feldstein-Horioka hypothesis states that if there is perfect capital mobility, a low correlation between domestic investment and savings should be observed. However, the empirical analysis failed to confirm the hypothesis. This study attempts to shed new light on international capital mobility by incorporating the effect of the fiscal balance and the financial balance. Specifically, for a panel of 161 countries over the 1990–2013 period, the extended model is tested in comparison with the existing models of capital mobility. At the aggregate level, strong support is found for the extended model; while, at the region disaggregated level, compared to the existing models the hypothesis of capital mobility holds for a larger number of regions. Our model and estimates are additionally extended to account for the fact that the above-mentioned relationships are conditional on the country’s level of financial development.
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Why is it important?
Another contribution of our study is to consider an alternative view of the Feldstein-Horioka puzzle. The existing approach used to test for capital mobility may be flawed, as the saving and investment relationship neglects important aspects of the financial system. The FH model assumes that the level of financial development of a country does not influence the ability of an economy to adjust their savings and taxes. Thus, we also account for the level of financial development of a country as a factor that drives the relationships between savings-investment, consumption, net output, and government-net taxes, and thereby affects the degree of capital mobility. Building upon the literature on financial development, we take into account that financial development not only encourages capital flows but also reflects the efficiency of financial institutions in dealing with financial frictions. We propose that one aspect of financial development is that it channels domestic savings into domestic investment, while another is that this may offset the effect of financial frictions on international capital flows.
Perspectives
In this paper, we revisit the Feldstein-Horioka puzzle. Namely, we consider the FH puzzle from the perspective suggested by Shibata and Shintani (1998), but we relax some of the original assumptions of their model. The primary point in our extended model is that we acknowledge that net output in autarky is different from the net output with capital mobility. This occurs due to the possibility of fiscal and saving-investment imbalances that can be caused by (i) international financing of government expenditure and investment, and (ii) the adjustment of saving and taxation due to capital mobility. Incorporating the abovementioned adjustment mechanisms into the original model imply that consumption in autarky, or the part of it that is independent of capital mobility, needs to be determined only by the variables that are also independent of capital mobility.
Dr Ratbek Dzhumashev
Monash University
Read the Original
This page is a summary of: The Feldstein-Horioka hypothesis revisited, Topics in Macroeconomics, January 2017, De Gruyter,
DOI: 10.1515/bejm-2016-0009.
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