Expectations Formation and the 1990 s ERM

The ERM crisis of 1992 appears to be due to a series of negative output shocks followed by devaluation. This stylised fact does not seem to conform to the “second-generation “ crisis model based on the REH. We show that by adopting bounded rational learning, the model yields a tradeoff between the size and persistence of shocks leading to devaluation, a finding which makes the model more clearly applicable to these crisis episodes.