An Alternative Explanation of the Price Puzzle

Stockholm School of Econ./EFI Working Paper No. 414

40 Pages Posted: 22 Apr 2001

Date Written: March 2001

Abstract

This paper proposes a simple explanation for the frequent appearance of a price puzzle in VARs designed for monetary policy analysis. It suggests that the best method of solving the puzzle implies a close connection between theory and empirics rather than the introduction of a commodity price. It proves that the omission of a measure of output gap (or potential output) spuriously produces a price puzzle (and several other incorrect conclusions) in a wide class of commonly used models. This can happen even if the model admits a triangular identification and if the forecasts produced by the misspecified VAR are optimal. When the model is tested on US data, all predictions are supported.

Keywords: VAR, monetary policy, misspecification, output gap, technology shocks

JEL Classification: E30, E52

Suggested Citation

Giordani, Paolo, An Alternative Explanation of the Price Puzzle (March 2001). Stockholm School of Econ./EFI Working Paper No. 414, Available at SSRN: https://ssrn.com/abstract=263298 or http://dx.doi.org/10.2139/ssrn.263298

Paolo Giordani (Contact Author)

Norwegian Business School ( email )

Nydalsveien 37
Oslo, 0442
Norway

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