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Solving the Feldstein–Horioka Puzzle With Financial Frictions
Author(s) -
Bai Yan,
Zhang Jing
Publication year - 2010
Publication title -
econometrica
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 16.7
H-Index - 199
eISSN - 1468-0262
pISSN - 0012-9682
DOI - 10.3982/ecta6619
Subject(s) - economics , investment (military) , capital (architecture) , enforcement , bond , capital flows , monetary economics , asset (computer security) , econometrics , finance , microeconomics , computer science , profit (economics) , computer security , archaeology , politics , political science , law , history
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, the two frictions interact to endogenously restrict capital flows and thereby solve the Feldstein–Horioka puzzle.