First generation models

the crisis is not a result of arbitragy markets

it is a result of government policies being inconsistent with maintaining a fixed exchange rate

government

runs a fiscal deficit that needs financing

Central bank

responsible for monetising debt

cb is allowing Stock of domestic credit (B)

to steadily expand, and will continue too forever

cb is currently fixing the exchnage rate

but will allow for floating when it runs out of reserves

issues with government policy

1. inconsistent with maintaining a fixed exchange rate

2. eventually reserves run out and fixed exchange rate will have to be abandoned

with perfect foresight

1st generation model predicts that the crisis is going to occue at time t=2

floating exchange rate

exchange rate if government had no foreign reserve

where fixed and floating exchange rate intersect

a speculative attack occurs forcing the end of fixed exchange rate

why can’t speculative attack occur at t=1

exchange rate will appreciate following the floating exchange rate, thus investors will experience a loss