Question

Describe and explain the long-run implications of the Feldstein-Horioka Hypothesis for the current account.

Answer 1

Feldstein-Horioka hypothesis states that if there is perfect capital mobility, low correlation between domestic investment and savings should be observed. It concerns that why levels of investment and saving are correlated across the countries. The hypothesis may have implications for related issues, and some of the long-run implications of the Feldstein-Horioka Hypothesis for the current account can be summed up as:
-   Implications for interest rates: As per the concept, the financial markets equalize real interest rates across countries and we might better understand the real interest rate in every country as being determined by the local supply & demand of loans.
-   Implications for exchange rates: According to the concept, if the real interest rate is higher in one country than another, it might be expected that the effect of arbitrage in international financial markets should be primarily on the exchange rate, and the agents will bid up the real value of the currency of the high interest rate country until they foresee the future fall in the value of that currency, or the risk of a fall in its value, offsets the expected gain from the interest rate differential.
-   Interest rate Equalization and Country’s GDP: In reference to the above discussions, If a country has higher real interest rates than its trading partners, agents in international financial markets will bid up the value of its currency and the appreciation or the depreciation of its currency will cause that country to incur a trade deficit or surplus, accordingly and hence influence and drive the country’s GDP.