The Price Puzzle: Fact or Artefact?

51 Pages Posted: 26 Jan 2006

See all articles by Efrem Castelnuovo

Efrem Castelnuovo

University of Melbourne - Department of Economics

Paolo Surico

London Business School - Department of Economics; Centre for Economic Policy Research (CEPR)

Date Written: January 2006

Abstract

This paper re-examines the empirical evidence on the price puzzle and proposes a new theoretical interpretation. Using structural VARs and two different identification strategies based on zero restrictions and sign restrictions, we find that the positive response of prices to a monetary policy shock is historically limited to the subsamples associated with a weak central bank response to inflation. These subsamples correspond to the pre-Volcker period for the United States and the period prior to the introduction of the inflation targeting framework for the United Kingdom. Using a micro-founded NewKeynesian monetary policy model for the US economy, we then show that the structural VARs are capable of reproducing the price puzzle from artificial data only when monetary policy is passive and hence multiple equilibria arise. In contrast, this model never generates on impact a positive inflation response to a policy shock. The omission in the VARs of a variable capturing the high persistence of expected inflation under indeterminacy is found to account for the price puzzle observed in actual data.

Keywords: Price Puzzle, DSGE model, Taylor principle, indeterminacy, SVARs

JEL Classification: E30, E52

Suggested Citation

Castelnuovo, Efrem and Surico, Paolo, The Price Puzzle: Fact or Artefact? (January 2006). Bank of England Working Paper No. 288. Available at SSRN: https://ssrn.com/abstract=878089 or http://dx.doi.org/10.2139/ssrn.878089

Efrem Castelnuovo (Contact Author)

University of Melbourne - Department of Economics ( email )

Melbourne, 3010
Australia

HOME PAGE: http://https://sites.google.com/site/efremcastelnuovo/home

Paolo Surico

London Business School - Department of Economics ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

HOME PAGE: http://sites.google.com/site/paolosurico

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

HOME PAGE: http://sites.google.com/site/paolosurico

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