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328 CHAPTER 11. BALANCE OF PAYMENTS CRISESIn more recent experience such as the European Monetary Systemcrisis of 1992 or the Asian crisis of 1997, few of the affected countriesappeared to be victims of macroeconomic mismanagement. Thesecrises seemed to occur independently of the macroeconomic fundamentalsand do not Þt intothemoldoftheÞrst generation models. Secondgenerationmodels were developed to understand these phenomenon. Inthese models, the government explicitly balances the costs of defendingtheexchangerateagainstthebeneÞts of realignment. The government’sdecision rule gives rise to multiple equilibria in which the costsof exchange rate defense depend on the public’s expectations. A shiftin the public’s expectations can alter the government’s cost-beneÞt calculationresulting in a shift from an equilibrium with a low-probabilityof devaluation to one with a high-probability of devaluation. Becausean ensuing crisis is made more likely by changing public opinion, thesemodels are also referred to as models of self-fulÞlling crises.11.1 A First-Generation ModelIn Þrst-generation models, the government exogeneously pursues Þscaland monetary policies that are inconsistent with the long-run maintenanceof a Þxed exchange rate. One way to motivate governmentbehavior of this sort is to argue that the government faces short-termdomestic Þnancing constraints that it feels are more important to satisfythan long-run maintenance of external balance. While this is nota completely satisfactory way to model the actions of the authorities,it allows us to focus on the behavior of speculators and their role ingenerating a crisis.Speculators observe the decline of the central bank’s internationalreserves and time a speculative attack in which they acquire the remainingreserves in an instant. Faced with the loss of all of its foreignexchange reserves, the central bank is forced to abandon the peg andto move to a free ßoat. The speculative attack on the central bank atduring the Þnal moments of the peg is called a balance of paymentsor a foreign exchange crisis. The original contribution is due to Krugman[89]. We’ll study the linear version of that model developed byFlood and Garber [55].