Six Puzzles in an Internationally Open Economy

1. Feldstein-Horioka Puzzle: Economic theory suggests that in an open economy,

capital should flow easily across borders to take advantage of investment

opportunities and equalize returns. However, empirical evidence shows that

savings and investments tend to stay within the same country. This puzzle

questions why capital mobility is limited despite the expectation of free

movement.

2. Lucas Paradox: According to economic theory, capital should flow from countries

with a surplus to those in need. However, in reality, capital tends to flow from

poorer countries to richer countries. This paradox challenges the traditional

understanding of how capital flows work and raises questions about why capital

doesn't flow as predicted.

3. Exchange Rate Disconnect Puzzle: The movements of exchange rates, which

determine the value of one currency relative to another, often do not seem to be

closely linked to economic factors such as interest rates or inflation. This puzzle

highlights the challenge of accurately predicting exchange rate movements

based solely on fundamental economic indicators.

4. Purchasing Power Parity (PPP) Puzzle: The concept of purchasing power parity

suggests that identical goods should have the same price when expressed in a

common currency. However, empirical studies have found persistent deviations

from this expectation, with goods often priced differently in different countries
 even after accounting for exchange rate changes. This puzzle raises questions

about why prices differ across countries in the long run.

5. Home Bias Puzzle: Despite the benefits of diversifying investments globally,

investors tend to have a preference for their home country's assets and hold a

larger share of their portfolios in domestic investments. This bias leads to an

imbalance in the allocation of capital across countries, and the puzzle lies in

understanding why investors exhibit this preference for home-country

investments.

6. Risk-Return Puzzle: Traditional financial theory suggests that higher risks should

be associated with the potential for higher investment returns. However,

empirical evidence shows that countries with higher economic and political risks

do not always generate correspondingly higher returns. This puzzle challenges

the conventional understanding of the risk-return relationship and calls for a

deeper understanding of how risk and return operate in international financial

markets.

These puzzles represent intriguing observations in the field of international open

economy, prompting researchers to explore and develop new theories and explanations

to better understand these phenomena.