Working Paper Series,
Sveriges Riksbank (Central Bank of Sweden)

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 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. In the framework of a model due to Svensson, the omission of a measure of output gap is shown to generate several other incorrect conclusions. When the model is tested on US data, all predictions are supported.

Keywords: VAR; monetary policy; misspecification; output gap; technology shocks.

JEL-codes: E30; E52

34 pages, September 1, 2001

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Paolo Giordani, (2004), 'An Alternative Explanation of the Price Puzzle', Journal of Monetary Economics, vol 51, no 6, pages 1271-1296

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