The Feldstein-Horioka puzzle: The IS-LM model with optimal policy

The high correlations between saving and investment, which suggest a small variability of the current account, is explored within an IS-LM framework. While Feldstein and Horioka interpret this evidence to imply a low degree of capital mobility, the pattern of shocks to the model is also important. If the monetary authorities are pegging domestic rates to foreign returns, then we would expect the Feldstein-Horioka evidence even under high mobility. We explore whether such a rule is optimal when policymakers wish to avoid income variability where fiscal and monetary policy are coordinated and where monetary policy must act alone. We suggest that the Voicker Federal Reserve switched to the latter stance and created a dramatic exception to the Feldstein-Horioka paradox.