The Price Puzzle and the Hysteresis Hypothesis: SVEC Analysis for the US Economy

ABSTRACT

This paper shows that monetary policy tightening may lead to an increase in the level of prices. To demonstrate this, we apply SVEC modelling to US monthly data for the 1959–2018 period and endorse the ‘hysteresis hypothesis’ which assumes that monetary policy produces long-lasting effects on unemployment and prices. Contrary to what has been argued by Hanson (2004. ‘The “Price Puzzle” Reconsidered.’ Journal of Monetary Economics 51 (7): 1385–1413) and Castelnuovo and Surico (2010. ‘Monetary Policy, Inflation Expectations and the Price Puzzle.’ The Economic Journal 120 (549): 1262–1283), the phenomenon known as the ‘price puzzle’ or ‘Gibson paradox’ is confirmed both in the pre-1979 and post-1982 periods, showing that the paradox is independent of the active/passive behaviour of the Central Bank. Our findings detect a cost channel of monetary policy demonstrating that a change in the interest rates by monetary authorities may have an effect on income distribution.

KEYWORDS:

• Price puzzle
• hysteresis
• SVEC
• US
• cost channel of monetary policy

JEL Classification:

• C32
• E43
• E52

Acknowledgment

We would like to thank INET for financial support of this research project. We would also like to acknowledge the insightful comments of two anonymous referees.

Disclosure Statement

No potential conflict of interest was reported by the author(s).

Notes

1 Their results show that sectoral output responses to monetary policy shocks are systematically related to industrial characteristics corroborating the hypothesis of Barth and Ramey (2002) that systematic differences in working capital needs are behind sectoral differences in the responses to monetary policy impulses.

2 Similar results are obtained by Gaiotti and Secchi (2006) for Italy employing a panel covering some 2,000 Italian manufacturing firms, with 14 years of data on prices and interest rates paid on several types of debt.

3 It has been rationalized into the New-Keynesian DSGE models by assuming that factors of production have to be paid by borrowing from financial intermediaries before the proceeds from the sale of output are received (Ravenna and Walsh 2006; Tillmann 2008). Interest rates would therefore affect firms’ marginal costs of production which in turn would drive inflation dynamics.

4 The effect also concerns own capital since the interest rate is the opportunity cost of capital. On other post-Keynesian economists who consider the Gibson paradox and interest as a cost which is passed on prices, see Moore (1988), Lavoie (1995), Wray (2007) and Rochon and Setterfield (2007).