Asymmetric Central Bank Reaction Function: An Application of Smooth Transition Regression

This paper estimates a simple model of exchange rate policy where the Central Bank optimises an objective function which takes into account competitiveness, its commitment to the EMU and the cost of adjustment. We allow for asymmetry in government behaviour whereby a key parameter, the marginal adjustment cost of the effective exchange rate, takes on a continuum of values depending on the value of the DeustscheMark/Irish pound exchange rate. It is shown that he adjustment cost parameter is decreasing in either the level of or the rate change of the DM rate suggesting that the authorities display greater aversion to exchange rate fluctuations as the domestic currency weakens. [C22, F31, F41]