SSE/EFI Working Paper Series in Economics and Finance
An alternative explanation of the price puzzle
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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