Econometrica: Mar 2010, Volume 78, Issue 2

Solving the Feldstein–Horioka Puzzle With Financial Frictions

https://doi.org/10.3982/ECTA6619
p. 603-632

Yan Bai, Jing Zhang

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 , where contracts are enforced by the threat of default penalties. The other is , 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.

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Supplemental Material

Supplement to "Solving the Feldstein-Horioka Puzzle with Financial Frictions"

PDF file of two technical appendices. Appendix 1 demonstrates how the optimal allocation in the bond-enforcement model can be decentralized into a competitive equilibrium with either national default risk or resident default risk.  Appendix 2 describes two alternative strategies to compute the bond-enforcement model.

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Supplement to "Solving the Feldstein-Horioka Puzzle with Financial Frictions"

Replication files for the manuscript.

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