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
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: Suggested Citation