Norges Bank

Working Paper

The price puzzle: Mixing the temporary and permanent monetary policy shocks

Author:
by Ida Wolden Bache and Kai Leitemo
Series:
Working Paper
Number:
18/2008

Abstract

We argue that the correct identification of monetary policy shocks in a vector autoregression requires that the identification scheme distinguishes between permanent and transitorymonetary policy shocks. The permanent shocks reflect changes in the inflation target while the transitory shocks represent temporary deviations from the interest rate reaction function. Whereas both shocks may raise the nominal interest rate on impact, the inflation and output responses of the two shocks are different. We show, using a simple simulation experiment, that a failure to distinguish between the two types of shocks can result in a ”price puzzle”.

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ISSN 1502-8190 (online)

Published 4 November 2008 16:08
Published 4 November 2008 16:08