DISCOUNT FACTORS AND THRESHOLDS: FOREIGN INVESTMENT WHEN ENFORCEMENT IS IMPERFECT

Abstract

We consider a model that provides insight intothewell-known Folk theorem in economics that when thediscountfactor β is sufficiently close to 1, expropriation willnever occur. Although this Folk theoremistrue in our model,our perspective is different. The discount factor β often is described as a “deep structural parameter” that isdifficultto alter at a point in time. In contrast, we analyze thedeterminants of two thresholds β and β^*thatsegment the unit interval on which β is defined into threesubintervals. These subintervals correspond to thethree possibleequilibria for investment flows: autarky, underinvestment, andunconstrained optimalinvestment. These thresholds are ofinterest because they can be altered by specific policyinterventions. Asa consequence, even if β is small, some level offoreign investment can be supported. We construct measuresof βfor 40 countries, characterize β and β^*, and discuss recent trends in investment flows.