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FORWARD-LOOKING INFORMATION IN VAR MODELS AND THE PRICE PUZZLE

Sophocles N. Brissimis

Bank of Greece and University of Piraeus

Nicholas S. Magginas

Athens University of Economics and Business and National Bank of Greece

ABSTRACT

In this paper we suggest a VAR specification that proves to be successful in resolving the price puzzle featuring in VARs used for monetary policy analysis. We show that augmenting a standard VAR with a small number of variables that have forward-looking informational content is capable of producing theory-consistent responses to monetary policy shocks. The VAR is estimated for the US with data covering the period 1989-2001, which is characterized by a relatively homogeneous monetary policy regime and a pronounced price puzzle in standard VAR specifications. Most important among these forward-looking variables are the federal funds rate future reflecting expectations of future monetary policy and a leading composite indicator providing information about near-term developments in economic activity. In view of the increasing ability of financial markets to better predict monetary policy movements, financial asset prices, such as the federal funds rate futures, are ideal candidates for incorporating parsimoniously a large amount of information into a lowdimension VAR.

Keywords: Monetary transmission mechanism; VAR models; Fed funds futures; price puzzle

JEL classification: E44; E52; F41; G1

We are grateful to Stelios Arvanitis, Antonis Demos and Heather Gibson, for helpful comments. The views expressed in this paper are those of the authors and do not necessarily reflect those of their respective institutions.

Correspondence:

Sophocles N. Brissimis,
Economic Research Department,
Bank of Greece, 21 E. Venizelos Av.,
102 50 Athens, Greece,
Tel. + 30 210 3202388
Email: sbrissimis@bankofgreece.gr


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