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The price puzzle: fact or artefact?

Author

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  • Efrem Castelnuovo
  • Paolo Surico
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 prices to a monetary policy shock is historically limited to the subsamples associated with a weak central bank response to inflation. These subsamples correspond to the pre-Volcker period for the United States and the period prior to the introduction of the inflation targeting framework for the United Kingdom. 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 from 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 in actual data.

Suggested Citation

  • Efrem Castelnuovo & Paolo Surico, 2006. "The price puzzle: fact or artefact?," Bank of England working papers 288, Bank of England.
    • Handle: RePEc:boe:boeewp:288
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    File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2006/WP288.pdf
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    More about this item

    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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