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11.2. A SECOND GENERATION MODEL 339reserves to mount a successful defense or has access to sufficient linesof credit for that purpose.The government now faces a binary choice problem. After observingthe output shock u and the wage w it can either maintain the Þx orrealign. To decide the appropriate course of action, compute the costsassociated with each choice and take the low-cost route.Maintenance costs. Suppose the exchange rate is Þxed at s 0 . Theexpected rate of depreciation is δ e =E 0 (s) − s 0 . If the governmentmaintains the Þx, adjustment costs are c d = c r = 0, and the depreciationrate is δ = 0. Substituting real wage w − s 0 = δ e and outputy = −αδ e − u into (11.29) gives the cost to the policy maker of maintainingthe Þx`M = 1 2 [αδe +ȳ + u] 2 . (11.30)Realignment Costs. If the government realigns, it does so according tothe optimal realignment rule (11.26) with a devaluation given byδ = α [α(w − s)+ȳ + u]. (11.31)θAdd and subtract (α 2 /θ)s 0 to the right side of (11.31). Noting thatδ e = w − s 0 and collecting terms givesδ = λ α [αδe +ȳ + u] . (11.32)Equating (11.31) and (11.32) you get the real wagew − s = θδe − α(ȳ + u). (11.33)α 2 + θSubstitute (11.33) into (11.23) to get the deviation of output from thetargetȳ − y =θθ + α 2 [αδe +ȳ + u] . (11.34)Substitute (11.32) and (11.34) into (11.29) to get the cost of realignment⎧⎨`R =⎩θ2(θ+α 2 ) [αδe +ȳ + u] 2 + c d if u>0θ2(θ+α 2 ) [αδe +ȳ + u] 2 + c r if u