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The Price Puzzle and Indeterminacy

  • Efrem Castelnuovo

    (University of Padua)

  • Paolo Surico

    (Bank of England & University of Bari)

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 DSGE sticky price model of 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, the DSGE 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 EconWPA in its series Macroeconomics with number 0507021.

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Length: 36 pages
Date of creation: 20 Jul 2005
Date of revision:
Handle: RePEc:wpa:wuwpma:0507021
Note: Type of Document - pdf; pages: 36
Contact details of provider: Web page: http://econwpa.repec.org

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