SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

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 (and several other incorrect conclusions) 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. When the model is tested on US data, all predictions are supported.

Keywords: Price puzzle; monetary policy; misspecification; output gap; potential output; technology shocks; VAR

JEL-codes: E30; E52

37 pages, First version: December 4, 2000. Revised: November 19, 2001. Earlier revisions: December 6, 2000, December 7, 2000, December 11, 2000, January 8, 2001, January 8, 2001, January 30, 2001, November 2, 2001, October 2, 2001, November 2, 2001.

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