Estimates of Feldstein-Horioka Equation:

- 18 -

Table 4

I/Y = a + g(S/Y)

Period

1963-1981

1963-1970

1971-1981

1963-1966

1967-1970

1971-1974

1975-1981

4.11
(2.07)

3.26
(1.59)

4.15
(2.75)

2.74
(1.45)

4.52
(1.95)

3.75
(2.50)

6.04
(3.32)

0.88
(0.09)

0.89
(0.06)

0.89
(0.12)

0.93
(0.06)

0.83
(0.08)

0.88
(0.10)

0.82
(0.15)

0.74

0.84

0.80

0.59

Note: Sample size is 23; standard

errors are in parentheses.


-12-

Table 1

Current Account and Domestic Saving Ratios: 1963-1981

Current Account-to GDP Ratio Domestic Saving to GDP Ratio

Average (Percent) Rank Average (Percent) Rank
Japan 0.5 4 34.9 1
Switzerland 1.7 1 29.7 2
Austria -0.7 ll 27.5 3
Norway -3.0 21 26.9 4
Portugal -2.0 15 25.7 5
Netherlands 0.5 3 24.9 6
Germany 0.5 5 24.9 7
Iceland -3.3 22 24.9 8
Finland -1.9 14 24.6 9
Greece -2.4 18 24.3 10
France 70.5 9 24.1 11
Australia -2.1 16 23.8 12
New Zealand -2.7 19 22.8 13
Italy 0.6 2 22.6 14
Spain -1.0 12 22.6 15
Sweden -0.6 10 22.5 16
Canada -1.1 13 22.3 7
Belgium -0.2 7 22.3 18
Denmark -2.8 20 20.7 19
Ireland -4.4 23 20.7 20
United States 0.2 6 19.4 21
United Kingdom -0.2 8 18.7 22
Turkey -2.2 V7 17.3 23



-22-

» “Aspects of the Current Account Behavior of OECD

Economies," in Claassen, E., and Salin, P., eds., Theory of

Flexible Exchange Rates, New York, 1983.

Tobin, James, "Comments," European Economic Review, 21, March-April
1983, 153-156.

Westphal, Uwe, "Comments," European Economic Review, 21, March-April

1983, 157-159,



II. Review of the Literature
In order to assess the degree of net international capital

motility Feldstein and Horioka estimate an equation of the form:

IY =a + g(S/Y) te,

where I, Y, and S are, respectively, gross domestic investment, GDP, and
gross domestic saving in a particular country; e is an error term. This
equation is estimated for 16 OECD countries over the 1960-1974 period
anc various sub-periods. Each country's average ratios for the entire
period or sub-period examined are taken to be one observation. In
taking averages over a number of years the authors are attempting to
abstract from cyclical influences. In recognition of the endogeneity of
the domestic saving ratio, Feldstein and Horioka estimate some equations
using a two stage least squares method. Expression of the variables in
ratio form makes it likely that e is homoskedastic.

Feldstein and Horioka find a value of 8 that is not
statistically different from unity. In contrast, according to the
authors, the hypothesis of perfect (net) international capital mobility
implies of value of zero for g. They state (p. 317) that "the
statistical estimates indicate that nearly all of incremental saving
remains in the country of origin." In his later paper, Feldstein states
(pp. 130-131): “it is reasonable to interpret the Feldstein-Horioka
firidings as evidence that there are substantial imperfections in the
international capital market and that a very large share of domestic

savings tends to remain in the home country." Anticipating the


- 19 -

It should be noted that when Feldstein and Horioka estimate a
regression of the change in the investment rate on the change in the

saving rate, they obtain (p. 327):

(8) A(I/Y) = + 0.724 [a(S/Y)],
)

0.2
(0.4) (0.158

where the units of the intercept term have been converted to be
comparable with the units used in this study. Feldstein and Horioka
interpret the estimated slope coefficient as being consistent with their
other findings of no net international capital mobility. It is not
clear why Feldstein and Horioka include an intercept term in equation
(8) and their time periods -- 1960-1969 and 1970-1974 -- do not coincide
with business cycles. In equation (7) of the present paper, an
intercept is not included and the OECD business cycle is taken as the
unit of observation. The resulting estimated slope coefficient
indicates even more net international capital mobility than is implied

by equation (8).


-21-

Literature Cited

Earle, John S., and Summers, Lawrence H., “Current Account Imbalances
and the International Mobility of Capital," unpublished paper,
1983.

Feldstein, Martin, "Domestic Saving and International Capital Movements
in the Long Run and the Short Run," European Economic Review, 21,
March-April 1983, 129-151.

» and Horioka, Charles, "Domestic Saving and International
Capital Flows," Economic Journal, 90, June 1980, 314-329.
Fieleke, Norman S., “National Saving and International Investment," in

Saving and Government Policy, proceedings of a conference sponsored

by the Federal Reserve Bank of Boston and held at Melvin Village,
New Hampshire, October 1982.

Fischer, Stanley, "Comment," Brookings Papers on Economic Activity,

1981:1, 273-280.

Harberger, Arnold C., "Vignettes on the World Capital Market," American
Economic Review, 70, May 1980, 331-337.

Organization for Economic Co-operation and Development, Historical
Statistics, Paris, 1983a.

» National Accounts, Paris, 1983b.

» National Accounts, Paris, 1984.

Penati, Alessandro, and Dooley, Michael, "Current Account Imbalances and
Capital Formation in Industrial Countries: 1949-1981," IMF
Departmental Memorandum, October 11, 1983.

Sachs, Jeffrey D., “The Current Account and Macroeconomic Adjustment in

the 1970s," Brookings Papers on Economic Activity, 1981:1, 201-268.



- 16 -

Table 3

Summary Statistics for A(CA/Y)/a(S/Y)

Standard Error

Average of the Average Observations
Table 2: Panel A 0.616 0.170 12
Table 2: Panel B 0.254 0.310 11
Table 2: Panel C 0.459 0.145 18

Table 2: All Panels 0.450 0.115 41



The competing proposition, generally referred to in this literature as

the "capital mobility" hypothesis, is:
(4) ACA/AS > 0.

The expanded accounting framework in equation (2) can be used
to examine some of the implications of the Feldstein-Horioka

proposition. From equation (2) one can obtain:
(5) ACA/AS = [a(T-G)/AS] + (aS,/4S) - (al /aS).

The various empirical tests that have been reported in the literature
and which are discussed in the preceding section have been inzerpreted
as confirming the Feldstein-Horioka proposition, that is, equation (3).
In discussing the policy implications of this result, the implicit
interpretation usually is that private domestic saving equals private
domestic investment and that there is no (net) private international
capital mobility. In other words, the presumption has been that the
result holds because aly = asa However, the existence of the
[a(T-G)/AS] term in equation (5) means that even if there were perfect
capital mobility, that is, even if al, = 0, equation (3) could hold if
the fiscal authorities acted to stabilize economic activity by taking
: steps to offset variations in private saving behavior or, indeed, if
they used fiscal policy to achieve a fixed current account target (as
suggested by Tobin, Westphal, and Earle and Summers). In either case,

an empirical result consistent with equation (3) would be attributable


As an example of an omitted factor, Tobin, Westphal, and Earle
and Summers have suggested that the empirical regularity underlying the
Feldstein-Horioka finding may reflect government policy. Governments,
when faced with a growing current account imbalance, may very weli adopt
macroeconomic policies designed to eliminate the imbalance. Such
behavior could be attributable to concern about either the current
account itself or the exchange rate. Another omitted factor might
involve risk considerations: domestic residents simply may be unwilling
to take open positions in foreign assets. (See Harberger for a
discussion of the role of risk factors as an explanation of the
Feldstein-Horioka result.)

In two recent papers concerning theoretical and empirical
aspects of the current account behavior of OECD countries, Sachs argues
that persistent current account imbalances can be expected between
countries with similar tastes but unequal marginal productivities of
capital or between countries with similar technologies but differing
intertemporal consumption preferences. He states that the former seems
to be the case when one compares small and large OECD countries. (The
small OECD countries tended to run persistent current account deficits
jn the 1960s and 1970s while recording domestic investment to GNP ratios
several percentage points above those of the large OECD countries.)

- Sachs presents some estimated equations in which investment ratios
appear to explain a considerable amount of OECD current account
developments. Such a result, of course, directly contradicts the

Feldstein-Horioka proposition. However, Sachs' approach suffers from


criticism that international capital mobility has increased over time,
especially in the last half of the 1970s, Feldstein extends the sample
through 1979. Although he finds most of the OECD countries running
current account deficits in the 1975-1979 period, the estimated value of
8B remains large. In fact, the value of 8 seems to be growing over
time.2/
It is difficult to interpret the estimates of a Feldstein-
Horioka equation without a structural model because many factors could
be, and probably were, responsible for the historical experience
recorded in the data. However, contrary to Feldstein, it does not seem
reasonable to interpret estimates of a large and statistically
significant value for B as evidence of “substantial imperfections" in
international capital markets. Observers of the large volume of (gross)
international capital flows tend to conclude that capital is quite
mobile across national borders and that, with the gradual dismantling of
exchange and capital controls in recent years, such mobility has
increased. Feldstein mentions the high degree of mobility of short-term
funds and the substantial level of gross flows of long-term capital.
Given these flows, it is likely that any link between domestic saving
and domestic investment is attributable not to barriers to mobility but
instead to other factors, none of which is included in the Feldstein-
Horioka equation. Moreover the existence of massive gross capital flows
makes it important to remember the qualifying term "net" in the
discussion of the Feldstein-Horioka proposition. The question in this
literature is about net capital flows and net international capital
mobility. In other words, the question concerns the economic role of

net foreign investment.


-l-

deviations were 2.89 and 2.50, respectively. The average absolute
values of A(S/Y) and A(I/Y) were 2.15 and 1.89, respectively. Thus,
during this sample period, saving rates were somewhat more volatile than
were investment rates.

For the full sample --that is, all 69 observations -- a
regression of A(I/Y) on A(S/Y) results in:

(7) A(I/Y) = 0.634 [a(S/Y)].
(0.069)

Contrary to the Feldstein-Horioka proposition, the estimated: coefficient
is statistically less than unity.

It is interesting to note that the conclusion about
international capital mobility reported in this study does not differ
from that of Feldstein, Horioka, and others simply because of the
different time periods and set of countries used. In Table 4, estimates
of the basic Feldstein-Horioka equation for various time periods are
reported using the same underlying data that are used for Tables 1-3 in
this paper. As is readily seen the estimates essentially are the same
as those reported by Feldstein, Horioka, and others -- the estimated 8
is close to unity. Taken at face value, the estimates in Table 4
indicate that the level of a country's domestic saving rate does not
-have much of an influence on its current account position. (As already
noted, the data reported in Table 1 of the present paper confirm this
point.) The empirical evidence presented in Tables 2 and 3 and equation
(7), on the other hand, indicate that changes in domestic saving rates
from one business cycle to the next may well have had an important

influence on OECD current accounts in recent years.


III. Accounting Framework

A country's current account (CA), or net lending to the rest
of the world, is defined to be the difference between its domestic

saving (S) and domestic investment (I). That is,
(1) CA = S-I.

The right-hand side of equation (1) can be decomposed into the
government budget deficit and the difference between the private

sector's domestic saving and investment. Thus,

(2) CA = (T-G) + (S,-1,)s
where T represents taxes, G represents government expenditures, and the
subscript p denotes the private sector.

As discussed in the preceding section, the Feldstein-Horioka
proposition is that there is no systematic relationship between
fluctuations in domestic saving and changes in a country's current
account other than a short-term cyclical relation that in effect
insulates domestic investment (saving) tc some extent from the cyclical
vagaries of domestic. saving (investment). Taking the business cycle as
the period of observation, the Feldstein-Horioka proposition can be

exoressed as:

(3) ACA/AS = 0.


- 23 -

Footnotes

This paper represents the views of the authors and should not be
interpreted as reflecting the views of the Board of Governors of the
Federal Reserve System or other members of its staff. We would like
to thank Doug Bell for his help with the data and computations and
our colleagues in the International Finance Division for their
helpful comments and suggestions.

Penati and Dooley, using a somewhat different sample, also find a
larger value for g in the 1970s. In another extension of the
Feldstein-Horioka study, Fieleke examines the experience of 87
countries -- including 69 non-industrial countries -- and finds
evidence that is consistent with the Feldstein-Horioka results.

Note that in some of the other studies in this literature Luxembourg
is viewed as a troublesome outlier.

The identification of the 1982 trough requires some estimation.

As mentioned in a preceeding section, in this study "medium-term" is
taken to mean from one business cycle period to the next. This
definition of the medium term seems to be consistent with that used

in the literature on the Feldstein-Horioka proposition.


International Finance Discussion Papers
Number 244

June 1984

DOMESTIC SAVING, CURRENT ACCOUNTS, AND
INTERNATIONAL CAPITAL MOBILITY

by

Gerard Caprio, Jr. and David H. Howard

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished materials)
should be cleared with the author or authors.


-~10-

IV. Data

In this study the experiences of 23 OECD countries during the
period 1963-1981 are examined using annual data. Two OECD countries are
omitted: Luxembourg is omitted because it is part of a monetary union
with a much larger country (Belgium) and the interpretation of capital
flows in such a case is not straightforward’ ; Yugoslavia is omitted
because the requisite data are not available. The period 1963-1981
includes four complete OECD business cycles: 1963-1966, 1967-1970,
1971-1974, and 1975-1981. The timing of the OECD business cycles is
based on the OECD publication, Historical Statistics, in which the
percentage deviations from trend for total OECD GDP are plotted (OECD,
1983a, p. 146). In this chart business cycle troughs in 1963, 1967,
1971, 1975, and 1982 can be identi fied.2/ For present purposes a
business cycle is defined to start the year in which there is a trough
and end the year preceding the year in which the next trough occurs.
The actual data used in this study are taken from another OECD
publication, National Accounts. Most of the data are from the 1984
edition of National Accounts (OECD, 1984) but for some countries the
1983 edition (OECD, 1983b) is used in order to obtain consistent series.
In some cases OECD estimates are used to adjust for breaks in the
series. The data in National Accounts are presented on a U.N. System of
National Accounts (SNA) basis. The accounts of all but three of the
countries are on the present SNA basis; those of Greece, Iceland, and
Switzerland are on the former SNA basis. The data are for calendar
years except for Australia and New Zealand where they are for fiscal
years. Gross domestic product in purchasers’ values at current prices
is specified to be Y; finance of gross accumulation is S; and net

lending to the rest of the world is CA.


to a government policy reaction function rather than to a lack of
private capital mobility. Since in many countries the fiscal
authorities have been concerned with correcting unwelcome fluctuations
in private sector demand and current account balances, it is not clear
that the usual conclusion about the lack of capital mobility which is
drawn in this literature is warranted. Furthermore, the empirical
evidence reported in the present paper casts doubt on the basic
Feldstein-Horioka proposition that fluctuations in domestic saving
between business cycles are not offset significantly by international
capital flows.

Equations (3) and (4) suggest a convenient and extremely
simple method of testing the Feldstein-Horioka proposition: compute the
average A(CA/Y)/a(S/Y) for a sample of countries and business cycles and
test its statistical significance. [The current account and domestic
saving are normalized on nominal GDP (Y) in order to avoid spurious
correlation attributable to price inflation and real growth.] Such a

test can be expressed as a regression equation:

(6) A(CA/Y)/A(S/Y) = ute,

where yw is the average of A(CA/Y)/A(S/Y) and e is an error term.
Equation (6) has some attractive features: the business cycle is used
as the period of observation; there are no endogenous right-hand side
variables; and e is very likely to be homoskedastic. The Feldstein-
Horioka proposition is that wy equals zero. The (net) capital mobility
Proposition is that u is greater than zero. Perfect (net) capital

mobility implies a value of unity for u.


d..woacks similar to those of the Feldstein-Horioka equation. Such
equations do not help in identifying underlying economic behavior
Furthermore, Penati and Dooley estimate the Sachs equations for 19 OECD
countries over various periods and find that the estimated coefficients
are unstable and are sensitive to the choice of countries in the sample.
In the simple framework used in the literature concerning the
Feldstein-Horioka proposition, questions about economic causality cannot
be addressed. Structural explanations for the empirical regularity that
is behind the results derived by Feldstein, Horioka, and others must
await more elaborate investigations. However, there is still scope for
further examination of this empirical regularity. The extent to which
variations in domestic saving historically have been associated with
variations in domestic investment and/or a country's current account in
the medium term is a useful piece of information. As a "stylized fact"
this information can help guide the development of macroeconomic
analysis. It is, of course, an empirical question. In addition, it is
a question of degree: it would be surprising to find that fluctuations
in domestic saving have been associated exclusively either with
fluctuations in domestic investment or with changes in the current

account.


- 20 -

VI. Conclusion

This paper examines the Feldstein-Horioka proposition that
over the medium run variations in a country's domestic saving rate are
reflected almost exclusively in offsetting movements in domestic
investment rather than in the country's current account. Data on 23
OECD countries for the four OECD business cycles during the period 1963-
1981 are used to investigate this proposition. The evidence presented
in this paper is inconsistent with the Feldstein-Horioka proposition;
that is, there appears to be a substantial degree of medium-term net
international capital mobility.

Nevertheless, it remains true that over long periods of time
-- for example, the 19-year period reported in Table 1 -- average
current accounts tend to be fairly small in absolute value. Some
possible explanations of this phenomenon are mentioned in a preceding
section. For macroeconomists and policy makers it is important to
understand why current accounts tend to cumulate to zero in the long
run. If, for example, the phenomenon reflects a government policy of
targeting on the current account, where the target value is something
small, then a change in policy regime can make this past experience
irrelevant and there can be no presumption that current accounts
necessarily will be balanced even in the long run. Thus, currerit
account developments -- particularly those that appear to be corinected
with switches in macroeconomic policy regimes -- cannot be assumed to be
transitory just because in the past such developments have tended to
cancel out over time. Further research into the economic determinants
of domestic saving, domestic investment, and the current account are
necessary before one can assess the nature of and proper policy response

to a particular movement in the current account.


role for international capital flows in insulating domestic investinent
(saving) from cyclical variations in domestic saving (investment ).]

The present paper reviews the relevant literature on the
Feldstein-Horioka proposition that there is no (net) international
capital mobility (that is, net foreign investment) and then examines the
empirical evidence. Data on OECD countries are used and the unit of
observation chosen is an OECD business cycle, of which there are four in
the sample period used in this study -- 1963-1981. The medium run is
defined in this study to mean from one business cycle to the next, that
is, two full business cycles -- a time span of nine years, on average.
It is found that the Feldstein-Horioka proposition is not correct
there appears to be a significant degree of net international capital
mobility in the medium run. However, the evidence presented in this
paper also indicates that net international capital is not perfectly
mobile. The point estimate reported here is that, on average, about
half of a change in a country's domestic saving rate from one OECD
business cycle to the next has been associated with movements in its
current account. In the final section of the paper some policy

implications are presented.


-13-

Table 2

Selected Data on Current Account and Domestic Saving Ratios

Japan
Switzerland
Portugal
Iceland
Finland

New Zealand
Sweden
Belgium
Denmark
Treland
United States
Turkey

Austria
Portugal
Iceland
Finland
Greece
Australia
New Zealand
Italy
Spain
Denmark
Turkey

Japan
Switzerland
Austria
Norway
Portugal
Netherlands
Germany
Finland
Greece
France
Australia
New Zealand
Spain
Sweden
Canada
Belgium
Denmark
Turkey

Panel A

1963-1966 Cyclo

Average (Percent.
any,

“ar oi
0.13 33.75 0.69
-1.46 29,79 1.96
-0./3 24.49 2.72
-0.94 26.58 -3.98
-1.85 22.72 = -0.75
=1:26 23,64 -0.84
-0.21 25.79 = -0.50
-0.13 22.80 1.23
71.65 23.43 -2.92
-3.06 18.55 -2.19
9.75 20.20 0.19
-1.73 14.11 -0,85
Panel B

1967-1970 Cycle

1967-1970
Average (Percent
CA oot

37.94
31.41
28.64
23.36
24.65
21.79
24.32
24,55
21.99
20.76
19.03
17.34

1971-1974 Cycle

Average (Percent

Average (Percent

28.14 = -0.16
28.64 1,23
23.36 = -5.38
24.65 -2.77
21.66 -2.46
24.76 = -0.23
21.79 -2.65
23.71 9 -0.79
23.54 0.14
21.99 -2.09
17.34 -0.10
Panel C

1971-1974 Cycle

30.43
31.15
24.77
27,46
28.18
25.97
24,95
22.24
24.90
23.13
19.75

1975-1981 Cycle

Average (Percent

2.09
-0.10

37.60
32.33
30.43
27,99
31.15
27.54
26.14
27.46
28.18
25.42
25.97
24.95
24,90
23.70
23.00
25.11
23,13
19.75

Average (Percent

9.32
3.88
71.76
-5.10
-7.16
0.51

32.35
27.12
25.33
25,99
21.46
21.38
21.83
23,96
25.49
22.19
21.35
21.55
20.61
18.81
21.60
19.08
17,00
17,57

A(CA/Y)/a(S/Y)

0.134
2.111
0.831
0.944
0.570
-0.227
0.197
0.806
0.882
0.394
0.479
0.272

A(CA/Y)/A(S/Y

-0.140
-0.594
-0.993
-0.719
0.113
1,893
-0.573
2.088
0.684
0.728
0.311

A(CA/Y)/a(S/Y)

0.112
~0.626
0.314
1.215
0.866
0.284
0.274
70.217
316
0.077
0.561
0.544
0.431
0.601
1.171
0.672
0.259
2.032

Note: See text for the criterion used to select the data.


-15-

V. Empirical Results

Table 3 reports the averages and standard errors of the
averages of the A(CA/Y)/A(S/Y) data that are presented in Table 2. In
all time periods examined in this study the average a(CA/Y)/A(S/Y) is
positive, although in the period covering the 1967-1970 to 1971-1974
cycles (Panel B) the average is not statisticlly significant. For all
41 observations, the average is 0.450, with a standard error of 0.115,
wnich is statistically significant. Thus, the experience of the OECD
countries during the 1963-1981 period indicates that only about half of
any change in domestic saving rates was matched by changes in domestic
investment in the medium term. The other half of the change in domestic
saving was associated with an international capital flow. It appears
that contrary to the conclusions of Feldstein, Horioka, and others there
is a large degree of net medium-term capital mobility in the world
economy. However, it also appears that the degree of capital mobility
is somewhat less than "perfect": the average A(CA/Y)/A(S/Y) is
significantly less than unity as well as significantly greater than
zero.

A similar exercise using data for A(CA/Y)/A(I/Y) yields an
average value of -0.085, which is not statistically significant. Thus
it would appear that for the 1963-1981 period taken as a whole,
fluctuations in domestic saving rates were more systematically
associated with current account developments than were variations in
domestic investment rates. (See Fischer's comments on Sachs' earlier
paper, p. 278.) The relative magnitude of fluctuations in saving and
investment can be obtained by pooling all 69 observations of A(S/Y) and
A(I/Y) in the sample. The average values for A(S/Y) and A(I/Y) were

-0.62 and -0.27 (percentage points), respectively, while their standard


Domestic Saving, Current Accounts

and International Mobility

Gerard Caprio, Jr., and David H. Howard*

Board of Governors of the Federal Reserve System

I. INTRODUCTION

In an important paper, Feldstein and Horioka challenge the
commonly held view that there is a high degree of capital mobility
between countries. In a later paper, Feldstein further elaborates and
refines this challenge. Feldstein and Horioka argue that in a world in
which there is perfect international capital mobility there should be no
correlation between a particular country's domestic saving and domestic
investment rates. Domestic saving is assumed to be determined by a
variety of factors -- including demographic characteristics, time
preference, and income distribution -- while domestic investment is
determined independently by rates of return. Each country faces a
perfectly elastic supply of capital at the world interest rate. In such
a world, a change in a country's domestic saving rate has no effect on
its domestic investment rate and, similarly, changes in domestic
investment do not influence domestic saving; instead, with perfect
capital mobility, such changes are reflected in the country's balance of
payments. Feldstein and Horioka present empirical evidence that
‘purports to refute the view that capital is highly mobile across
national borders. Their evidence seems to indicate that there is a
substantial -- indeed nearly perfect -- correlation between a country's
domestic saving and domestic investment rates over the medium run.

[Feldstein and Horioka concede that there may be a short-run or cyclical


Title: Domestic ‘Saving, Current Accounts, and International Capital
Mobi lity

Author: Gerard Caprio, Jr. and David H. Howard

Address: Board of Governors of the Federal Reserve System, Washington,
D.C. 20551

Date: June 1984

Series and Number: International Finance Discussion Papers, No. 244
Pages: 23

Price: No charge

JEL Subject Classification: 431

Keywords: Capital mobility, Feldstein-Horioka hypothesis, Saving and
Investment

This paper examines the Feldstein-Horioka proposition that
over the medium run variations in a country's domestic saving rate are
reflected almost exclusively in offsetting movements in domestic
investment rather than in the country's current account. Data on 23
OECD countries for the four OECD business cycles during the period 1963-
1981 are used to investigate this proposition. The evidence presented
in this paper is inconsistent with the Feldstein-Horioka proposition;
that is, there appears to be a substantial degree of medium-term net
international capital mobility. Nevertheless, it is found that over
long periods of time average current accounts tend to be fairly small in
absolute value. Some possible explanations of this phenomenon are

presented and policy implications are discussed.


-ll-

In Table 1 average current account and domestic saving ratios
for the period 1963-1981 are presented. There are two noteworthy
features of Table 1. First, the average current account to GDP ratios
for the OECD countries tend to be fairly small numbers in absolute
value, especially for the major countries. In other words, current
accounts over this particular period tended to cumulate to zero.

Second, there seems to be little if any connection between the relative
domestic saving performance of a country and the relative strength of
its current account. (The rank correlation between the current account
and comestic saving ratios reported in Table 1 is 0.20.) The empirical
investigations of Feldstein, Horioka, and others bring out these two
features of the data in various ways and lead the investigators to the
conclusion that there is no significant medium-term net ‘capital mobility
across national borders. This explanation of the data as well as other
explanations are discussed in a preceding section of this paper.

These two features of the data in Table 1 are interesting and
merit investigation. However, it is also interesting that further
scrutiny of the data that are used to construct Table 1 reveals a
significant amount of medium-term net international capital mobility </
Data for selected countries during the four OECD business cycles during
the 1963-1981 period are presented in Table 2. The countries selected
are those in which there was a change in the domestic saving ratio of at
least one percentage point in absolute value from one business cycle to
the next. (Small changes in saving ratios are eliminated for arithmetic
reasons; the actual choice of one percentage point as the cutoff is
arbitrary.) The righthand column in Table 2 contains the data that are
used in this paper's empirical tests. The formal tests are discussed in

the next section, but at this point it is interesting to note that there


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are very few negative entries in the column. Only nine -- 22 percent --
of the entries are negative, whereas the Feldstein-Horioka proposition
would lead one to expect that there would be approximately as many
negative as positive values for A(CA/Y)/A(S/Y). (In the full sample --
that is, including countries with negligible changes in their domestic
saving ratios -- 36 percent of the entries are negative. )

Panel C of Table 2 is particularty interesting because -of the
dramatic changes in domestic saving ratios which took place between the
1971-1974 cycle and the 1975-1981 cycle. The oi] and commodity price
shocks of 1973-1974 adversely affected the terms of trade and
consumption standards of the OECD countries. The reaction in nearly all
of these countries was a significant reduction in the saving ratio. In
almost every instance, the reduction in domestic saving was not matched
fully by changes in domestic investment, but rather was accompanied by a
weakening in the current account balance. The negative swing in the
current account reflected an inflow of foreign capital that softened the
impact of the change in domestic saving on domestic investment. Thus,
during this particularly turbulent eleven year period, net international
capital mobility was very much an important factor in determining the
pace and nature of economic activity in the OECD countries. Panels A
and B of Table 2 indicate that in less turbulent times international
capital flows also appear to play an important role as a buffer between
changes in domestic saving rates and changes in domestic investment:

rates.