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11.2. A SECOND GENERATION MODEL 33511.2 A Second Generation ModelIn Þrst-generation models, exogenous domestic credit expansion causesinternational reserves to decline in order to maintain a constant moneysupply that is consistent with the Þxed exchange rate. A key featureof second generation models is that they explicitly account for the policyoptions available to the authorities. To defend the exchange rate,the government may have to borrow foreign exchange reserves, raise domesticinterest rates, reduce the budget deÞcit and/or impose exchangecontrols. Exchange rate defense is therefore costly. The government’swillingness to bear these costs depend in part on the state of the economy.Whether the economy is in the good state or in the bad statein turn depends on the public’s expectations. The government engagesin a cost-beneÞt calculation to decide whether to defend the exchangerate or to realign.We will study the canonical second generation model due to Obstfeld[112]. In this model, the government’s decision rule is nonlinear andleads to multiple (two) equilibria. One equilibrium has low probabilityof devaluation whereas the other has a high probability. The costs tothe authorities of maintaining the Þxedexchangeratedependonthepublic’s expectations of future policy. An exogenous event that changesthe public’s expectations can therefore raise the government’s assessmentof the cost of exchange rate maintenance leading to a switch fromthe low-probability of devaluation equilibrium to the high-probabilityof devaluation equilibrium.What sorts of market-sentiment shifting events are we talking about?Obstfeld offers several examples that may have altered public expectationsprior to the 1992 EMS crisis: The rejection by the Danish publicof the Maastrict Treaty in June 1992, a sharp rise in Swedish unemployment,and various public announcements by authorities that suggesteda weakening resolve to defend the exchange rate. In regard tothe Asian crisis, expectations may have shifted as information aboutover-expansion in Thai real-estate investment and poor investment allocationof Korean Chaebol came to light.