Cointegration with Structural Breaks : An Application to the Feldstein-Horioka Puzzle

This paper revisits the well known Feldstein-Horioka saving-investment correlation puzzle from a time series perspective using a sample of 21 OECD countries. We argue that the strong positive correlation between saving and investment as originally identified by Feldstein and Horioka (1980) arises due to the neglect of the nonstationary properties of the variables as well as the failure to account for potential instabilities in the long run relationship between them. Our methodology is based on instability tests recently proposed in Kejriwal and Perron (2006a) as well as the cointegration test in Arai and Kurozumi (2005) extended to allow for multiple breaks under the null hypothesis of cointegration. Our empirical results show that for all countries except Mexico and the U.K., the cointegrating relationship has changed over time; in most cases, the change being towards a lower saving-investment correlation regime. This is perfectly consistent with the recent evidence on international diversification and integration of world capital markets. Finally, we find that while the saving-investment link bears a close relationship with the degree of openness of the country, there seems to be very little evidence in favour of the commonly held view that the correlation varies with the size of the country.(This abstract was borrowed from another version of this item.)