Discount factors and thresholds: Foreign investment when enforcement is imperfect

Abstract

We consider a model that provides insight into the well-known Folk theorem in economics that when the discount factor beta is sufficiently close to 1, expropriation will never occur. Although this Folk theorem is true in our model, our perspective is different. The discount factor beta often is described as a "deep structural parameter" that is difficult to alter at a point in time. In contrast, we analyze the determinants of two thresholds <(beta)under bar> and beta* that segment the unit interval on which beta is defined into three subintervals. These subintervals correspond to the three possible equilibria for investment flows: autarky, underinvestment, and unconstrained optimal investment. These thresholds are of interest because they can be altered by specific policy interventions. As a consequence, even if beta is small, some level of foreign investment can be supported. We construct measures of beta for 40 countries, characterize <(beta)under bar> and beta*, and discuss recent trends in investment flows.