In this two country OLG model there is a potential role for active governments since
markets are incomplete. There are many coordinated policies (exchange rate regimes) that result
in an optimal allocation if extrinsic uncertainty plays no role. However, if we take into account
the possibility of sunspot equilibria, the set of optimal policies is drastically reduced. Whenever
there is a possibility of influence by extrinsic uncertainty, one or both governments may seek to
avoid this by intervening on the foreign exchange markets. When only one country does so, this
may lead to a currency crisis, where the central bank is active and is with positive probability
unsuccessful in its attempt to defend its currency. If the two countries form a monetary union,
a coordinated fiscal policy is needed as a substitute for an optimal exchange rate regime.