RDP 2020-01: Credit Spreads, Monetary Policy and the Price Puzzle Appendix A: Literature Review

For Australia, early research finds mixed evidence for the response of prices to monetary policy (no price puzzle in Dungey and Pagan (2000); Berkelmans (2005); price puzzle in Suzuki (2004); Beechey and Österholm (2008); Lawson and Rees (2008)). Brischetto and Voss (1999) find that controlling for US interest rates and the Australian dollar exchange rate is crucial to remove the price puzzle. Using more recent data, Jacobs and Rayner (2012) and Phan (2014) find strong price puzzles even in similar (successful) specifications to the earlier Australian research. This has raised the question whether identification of the effects of monetary policy in Australia has become more difficult since the advent of inflation targeting in the early 1990s. Using a simulation study, Jääskelä and Jennings (2010) find that standard identification schemes typically deliver a price puzzle and hence suggest using a sign-restriction identification approach which delivers the desired response by construction. Most recently, Hartigan and Morley (2018) propose that the price puzzle can be resolved using a factor augmented VAR (FAVAR), which better accounts for the vast information the Bank uses when producing its forecasts.

Table A1: Cash Rate Effects on Prices – Previous Estimates from Australian SVARS
Paper Method and sample Price puzzle Peak/trough response Discussion
Brischetto and Voss (1999) SVAR(6), 7-variate, zero restrictions motivated by theory, 1980:Q1–1998:Q4 No (in preferred specification), response not significant Price level: 0.12%, 2 qtrs / –0.8%, 10 qtrs No price puzzle only when allowing for contemporaneous response of the cash rate to US federal funds rate and to nominal AUD/USD exchange rate
Dungey and Pagan (2000) SVAR(3), 11-variate, selected lags, zero restrictions motivated by theory, 1980:Q1–1998:Q3 No Inflation: –0.1 ppt, 10 qtrs (1 standard deviation shock) Price level: trough after 18 qtrs, magnitude unclear  
Suzuki (2004) SVAR(2), 11-variate, recursive, 1985:Q1–2000:Q2 Yes Price level: 0.2%, 3 qtrs Small price puzzle in unrestricted model, strong and significant puzzle in restricted model
Berkelmans (2005) SVAR(3), 7-variate, zero restrictions motivated by theory, 1983:Q4–2003:Q4 No Inflation: –0.2 ppt, 12 qtrs  
Beechey and Österholm (2008) Bayesian SVAR(3), 7-variate, recursive, 1985:Q1–2006:Q3 Yes Inflation: 0.1 ppt, 4 qtrs / –0.1, 10 qtrs  
Lawson and Rees (2008) Sectoral SVAR(3), 11-variate, zero restrictions motivated by theory, 1983:Q4–2007:Q3 Yes, insignificant Inflation: 0.06 ppt, 3 qtrs / –0.5 ppt, 8 qtrs  
Jääskelä and Jennings (2010) SVAR, 7-variate, sign restrictions, 1984:Q1–2009:Q4 No, by construction Inflation: –0.3 ppt, impact  
Jacobs and Rayner (2012) SVAR(2), 11-variate, 1983:Q4–2011:Q4 Yes, significant Inflation: 0.05 ppt, 5 qtrs Price puzzle becomes insignificant if a measure of inflation expectations is added
Phan (2014) SVARs, various specifications, recursive, 1982:Q3–2007:Q4 Yes, significant Price level: 0.2–0.4%, 6 qtrs  
Bishop and Tulip (2017) Univariate models and SVARs, various specifications, Romer and Romer (2004) identification, 1994:Q2–2015:Q4 Yes Price level: 0.5–1.5%, 8 qtrs  
Kim and Lim (2018) SVAR(6), 6-variate, sign restrictions, 1993:Q1–2014:Q3 No, by construction Price level: –0.1%, 3 qtrs  
Florio (2018) SVAR(1), 3-variate, recursive, 1976:Q3–2007:Q4 Yes, significant Price level: 0.7%, 10 qtrs Significant price puzzle pre-inflation targeting, insignificant but equally strong thereafter
Hartigan and Morley (2018) FAVAR(2), recursive, 1976:Q4–2017:Q2 No Inflation: 0.3 ppt, 10 qtrs Price level: 6%, 36 qtrs  
Notes: Peak and trough effects are to a 1 percentage point monetary policy shock, where provided by the author(s); effects are often approximated from graphical display of estimated effects; the shock is always contractionary and temporary, but the cash rate evolves endogenously after the shock and persistence may vary