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The Feldstein-Horioka Puzzle and Spurious Ratio Correlation

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  • Chu, Kam Hon

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.

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  • Chu, Kam Hon, 2012. "The Feldstein-Horioka Puzzle and Spurious Ratio Correlation," Journal of International Money and Finance, Elsevier, vol. 31(2), pages 292-309.
    • Handle: RePEc:eee:jimfin:v:31:y:2012:i:2:p:292-309
    DOI: 10.1016/j.jimonfin.2011.11.015
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    More about this item

    Keywords

    Feldstein-Horioka puzzle; International Capital Mobility; Investment-saving correlation; Spurious Ratio Correlation;
    All these keywords.

    JEL classification:

    • C2 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables
    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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