The Dynamics of Currency, Savings, and Investment Rates

• Author: Walid Ben Omrane,Skander Lazrak,Jie Yang,Mohamed A. Ayadi
• Published date: 01 March 2018
• Date: 01 March 2018
• DOI: http://doi.org/10.1111/irfi.12138

The Dynamics of Currency, Savings,

and Investment Rates*

MOHAMED A. AYADI,WALID BEN OMRANE,SKANDER LAZRAK AND

JIE YANG

Department of Finance, Operations, and Information Systems, Goodman School of

Business, St. Catharines, Canada

ABSTRACT

This paper examines the dynamic relations among foreign exchange rates,

savings, and investment ratio for a sample of 25 countries from the

Organization for Economic Cooperation and Development. We find that the

savings rate and the investment rate are cointegrated of order (1, 1). This

result is consistent with the literature on the savings–investment relations

and therefore confirms the validity of the Feldstein–Horioka puzzle. Using

country-specific and longitudinal panel vector autoregressive models, we

show that historical savings–investment differentials do not help explain

foreign exchange rates. We demonstrate, however, that foreign exchange rates

and trade balance ratio impact the difference between savings and

investments. Specifically, depreciation in the domestic currency would cause

the savings–investment difference to widen.

JEL classification: F31; F41; G15

I. INTRODUCTION

Obstfeld and Rogoff (2000) list and investigate six major puzzles in international

macroeconomics. They label them respectively as (i) the home bias in trade

puzzle, (ii) the Feldstein–Horioka puzzle, (iii) the home bias in equity portfolio

puzzle, (iv) the international consumption correlation puzzle, (v) the purchasing

power parity puzzle, and (vi) the exchange rate disconnect puzzle. Simply put,

the last puzzle states that foreign exchange rates are disconnected from any

macroeconomic aggregate including price levels, which are the object of puzzle

(v). Numerous studies document the exchange rates’unpredictability. The use

of forward exchange rates as a predictor of future rates and the risk premium

hypothesis explanation is largely tested in the literature.

1

Macroeconomic

models of open economies were developed that led to restrictions on the foreign

* Financial support from the CPA Ontario Research Excellence Center is gratefully acknowledged.

We would like to thank Tomson Ogwang for his many helpful comments. The usual disclaimer

applies. Please do not quote without the authors’permission.

1 See for instance Aggarwal et al. (2009) and Loring and Lucey (2013).

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12138

International Review of Finance, 18:1, 2018: pp. 3–33

DOI:10.1111/irfi .12138

© 2017 International Review of Finance Ltd. 2017

exchange rates.

2

Empirical evidence support that these restrictions are generally

not valid.

The Feldstein and Horioka puzzle is about the strong connection between

savings and investment rates (IRs) within a domestic open economy. In an open

economy with total capital mobility, domestic savings and investments should

not be related. International capital markets are supposed to balance the

difference through either capital inflows or outflows. For instance, suppose that

the domestic agents within one country do not save enough to fund domestic

investment needs. If capital is unrestricted to flow across national boundaries,

then domestic agents can borrow capital abroad to fund the extra investments.

Alternatively, if the nationals within a country save more than the required

domestic investments, the excess capital can be invested to fund foreign

opportunities. In summary, national savings and domestic investments should

be uncorrelated under absolute international capital mobility.

Feldstein and Horioka (1980) report, however, significant and strong

positive correlation between the domestic savings rate (SR) and the domestic

IR for a sample of Organization for Economic Cooperation and Development

(OECD) countries. Such result would imply that capital mobility is limited

and strongly imperfect.

We conjecture that puzzles (ii) and (vi) in Obstfield and Rogoff (2000) are

connected through capital mobility hypothesis. The latter suggests that if savings

are higher than required domestic investments and capital formation including

increase in inventories, then excess savings should transfer from the domestic

economy to be invested abroad where better opportunities exist. The domestic

funds need to be converted into foreign currencies to the end. This transaction

affects both the demand and supply of foreign and domestic currencies upon

investment and inversely when domestic savers send back home their dividends

or capital gains. Conversely, when domestic investments are higher than local

savings, foreign capital must flow into the domestic economy to finance the

extra investment opportunities. Foreign funds must be exchanged into domestic

funds to achieve these investments. Foreign savers would also convert the

payoffs of the investments back into their domestic currencies, respectively, for

their own consumption purposes. These currency exchanges should affect the

short-term and probably long-term relative currency prices.

The objective of this paper is therefore to study the effect of changes in

savings–investment differentials (SIDs) on foreign exchange rates by using a

longitudinal data set of 25 OECD economies over a period covering three decades

from 1980 to 2013. More formally, we aim to investigate whether the SID helps

predict the foreign exchange rates beyond the usual random walk model. We also

recognize that exchange rates may affect the behavior of the savings and

investment within a single domestic economy. Foreign savers will invest in

domestic economy conditional not only on the local expected investment

returns but also returns in their home local currencies as their end uses such as

2 See Uribe and Schmitt-Grohé (2017).

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