Intertemporal Incentives, Equilibrium Selection and Rational Investment Collapse

Abstract

In this paper we model the process of international investment flows when agents face strategic motives. We show that domestic agents' expectations about the behavior of foreign investors are crucial in the process of the determination of the equilibrium of the domestic economy. Specifically, we illustrate that domestic agents' beliefs about the level of foreign investment can serve as an equilibrium selector and in particular can lead to a selection of an inferior equilibrium with no foreign investment. Moreover, unlike other contributions we do not treat beliefs as exogenous, but rather we treat beliefs as a part of equilibrium and ensure that beliefs are consistent with the model. Specifically, we show that agents expectations about rational foreign investors leaving with probability q per period are in fact verified in equilibrium and rational foreign investors do in fact leave with probability q per period.