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The Economic Research Institute, Stockholm School of Economics SSE/EFI Working Paper Series in Economics and Finance

No 414:
An alternative explanation of the price puzzle

Paolo Giordani ()

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: Price puzzle; monetary policy; misspecification; output gap; potential output; technology shocks; VAR; (follow links to similar papers)

JEL-Codes: E30; E52; (follow links to similar papers)

37 pages, December 4, 2000, Revised November 19, 2001

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