Can exchange rate pass-through explain the price puzzle?

- The price puzzle is examined using a macro model with expectations formed rationally.
- We show that presence of a cost channel is necessary for the price puzzle to occur.
- The price puzzle occurs in a closed economy even if the cost channel is not strong.
- Our model shows that exchange rate pass-through can resolve the price puzzle.

The anomalous behavior of inflation in response to contractionary monetary policy is known as the price puzzle. Using a simple open-economy macroeconomic model, with expectations formed rationally, we show that exchange rate pass-through can help in resolving the price puzzle.