Solving the price puzzle with an alternative indicator of monetary policy

- In a recursive setting a-la-CEE(1999) we employ DIVISIA M4 as a policy indicator variable competing with the Federal funds rate.
- We find the standard result that the Federal funds rate requires commodity prices to resolve the price puzzle.
- DIVISIA specification also produces sensible responses until the end 2007.
- Unlike the Federal funds rate model, our DIVISIA specification can be extended beyond 2007.
- DIVISIA produces sensible results throughout the sample without inclusion of ad hoc commodity prices.

We identify the effects of monetary policy shocks on macroeconomic variables in VARs using the Divisia M4 measure of money as the policy indicator variable. We obtain theoretically sensible responses-whether or not a commodity price index is included. Thus, we eliminate the well-known empirical puzzles from the VAR by a novel choice in a policy variable, rather than the usual attachment of an ad hoc variable.