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The Feldstein-Horioka Puzzle and Spurious Ratio Correlation

  • Chu, Kam Hon
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    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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    Article provided by Elsevier in its journal Journal of International Money and Finance.

    Volume (Year): 31 (2012)
    Issue (Month): 2 ()
    Pages: 292-309

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    Handle: RePEc:eee:jimfin:v:31:y:2012:i:2:p:292-309
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