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Monetary Policy, Inflation Expectations and The Price Puzzle

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  • Efrem Castelnuovo
  • Paolo Surico

Abstract

This article re-examines the VAR evidence on the price puzzle and proposes a new theoretical interpretation. Using actual data and two identification strategies based on zero restrictions and "model-consistent" sign restrictions, we find that the positive response of prices to a monetary policy shock is historically limited to the sub-samples that are typically associated with a "weak" interest rate response to inflation. Using pseudo data generated by a "sticky price model" of the US economy, we then show that the structural VARs are capable of reproducing the price puzzle "only" when monetary policy is "passive". The omission in the VARs of a variable capturing "expected inflation" is found to account for the price puzzle observed in simulated and actual data. Copyright (C) Bank of England. Journal compilation (C) Royal Economic Society 2010.

Suggested Citation

  • Efrem Castelnuovo & Paolo Surico, 2010. "Monetary Policy, Inflation Expectations and The Price Puzzle," Economic Journal, Royal Economic Society, vol. 120(549), pages 1262-1283, December.
  • Handle: RePEc:ecj:econjl:v:120:y:2010:i:549:p:1262-1283
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    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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