This article is a revised version of the Bank of England Working Paper No. 266-2006 entitled ‘Price Puzzle: Fact or Artefact?’. We thank Andrew Scott and two anonymous referees for useful comments and suggestions. We are also grateful to Peter Andrews, Luca Benati, Gianluca Benigno, Pierpaolo Benigno, Giacomo Carboni, Larry Christiano, Tim Cogley, Marco Del Negro, Luca Gambetti, Marc Giannoni, Paolo Giordani, Thomas Lubik, Haroon Mumtaz, Salvatore Nisticò, Harald Uhlig, Guglielmo Weber and participants at the Quantitative Macroeconomics Research Network (Hamburg), University of Padua, Bank of England, X SMYE (Geneva), Bocconi University, 34th ACE (Melbourne), Reserve Bank of Australia, University of Sidney, IV Macroeconomic Dynamics Workshop (Bologna), University of Glasgow, Sveriges Riksbank, RES 2008 (University of Warwick) and LUISS for very useful feedback. The views expressed are those of the authors and do not necessarily reflect those of the Bank of Finland.
Monetary Policy, Inflation Expectations and The Price Puzzle*
Article first published online: 16 NOV 2010
© Bank of England. Journal compilation © Royal Economic Society 2010
The Economic Journal
Volume 120, Issue 549, pages 1262–1283, December 2010
How to Cite
Castelnuovo, E. and Surico, P. (2010), Monetary Policy, Inflation Expectations and The Price Puzzle. The Economic Journal, 120: 1262–1283. doi: 10.1111/j.1468-0297.2010.02368.x
- Issue published online: 16 NOV 2010
- Article first published online: 16 NOV 2010
- Submitted: 6 June 2008 Accepted: 14 October 2009
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.