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338 CHAPTER 11. BALANCE OF PAYMENTS CRISESNow, you can get the rational expectations equilibrium depreciationrate by substituting (11.27) into (11.26)⇐(226)δ = αȳθ + λuα . (11.28)The equilibrium depreciation rate exhibits a systematic bias as a resultof the output distortion ȳ. 3 . The government has an incentive to sety =ȳ. Seeing that today’s nominal wage is predetermined, it attemptsto exploit this temporary rigidity to move output closer to its targetvalue. The problem is that the public knows that the government willdo this and they take this behavior into account in setting the wage.The result is that the government’s behavior causes the public to set awage that is higher than it would set otherwise.Fixed Exchange RatesThe foregoing is an analysis of a managed ßoat. Now, we introducea reason for the government to Þx the exchange rate. Assume that inaddition to the costs associated with policy errors given in (11.25), thegovernment pays a penalty for adjusting the exchange rate. Where doesthis cost come from? Perhaps there are distributional effects associatedwith exchange rate changes where the losers seek retribution on thepolicy maker. The groups harmed in a revaluation may differ fromthose harmed in a devaluation so we want to allow for differential costsassociated with devaluation and revaluation. 4 So let c d be the costassociated with a devaluation and c r be the cost associated with arevaluation. The modiÞed current-period loss function is` = θ 2 (δ)2 + 1 2 (ȳ − y)2 + c d z d + c r z r , (11.29)where z d =1ifδ > 0andis0otherwise,andz r =1ifδ < 0 and is zerootherwise. We also assume that the central bank either has sufficient3 This is the inßationary bias that arises in Barro and Gordon’s [7] model ofmonetary policy4 Devaluation is an increase in s which results in a lower foreign exchange valueof the domestic currency. Revaluation is a decrease in s, which raises the foreignexchange value of the domestic currency.