No 125. An Alternative Explanation of the Price Puzzle

by Paolo Giordani

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 Classification: E30, E52.