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The Price Puzzle: Fact or Artifact?

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  • Efrem Castelnuovo

    ()
    (University of Padua)

  • Paolo Surico

    ()
    (University of Bari and Bank of England)

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 price to a monetary policy shock is historically limited to the sub-samples associated with a weak central bank response to inflation. These sub-samples correspond to the pre-Volcker period for the US and the pre-inflation targeting regime for the UK. Using a micro-founded New Keynesian monetary policy model for the US economy, we then show that the structural VARs are capable of reproducing the price puzzle on 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 on actual data.

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Paper provided by Dipartimento di Scienze Economiche "Marco Fanno" in its series "Marco Fanno" Working Papers with number 0016.

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Length: 38 pages
Date of creation: May 2006
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Handle: RePEc:pad:wpaper:0016

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