Appendix A. Additional Graphs and Results
We would like to thank Christian Ebeke and Ben Hunt for useful comments and suggestions.
In general, ignoring changes in the inflation target in a VAR setting might lead to a phenomenon called price puzzle, i.e., increases in nominal interest rate leads to higher price level, or inflation. Take the case of Poland’s disinflation for instance. Both inflation and interest rates have been trending downwards on account of two factors: a consistent decrease of the inflation target and active monetary policy that sought to anchor inflation expectations. If we specify a VAR using inflation and interest rates, the positive correlation of those variables at low frequencies may contribute to results displaying the price puzzle. For instance, Wolden Bache and Leitemo (2008) illustrate using a simulation experiment with a DSGE model that correct identification of monetary policy shocks in a VAR requires that the model distinguishes between transitory and permanent policy shocks (i.e. change in the inflation target).
Alternatively, we could have specified a dynamic factor model (DFM) to capture common and idiosyncratic dynamics in both regions. We choose a VAR model, however, as the data would have a VAR representation even in the case when the factor model would be the true representation of the data.
Our solution is to separate cyclical dynamics from the trend ones. An alternative would be to specify Vector Error-Correction Model (VECM). The strategy would, however, imply that long-run and cyclical dynamics are driven by the same shocks. Using VECM would not also free us from being careful about the steady state of the model and modeling inflation deviation from a time-varying target. Further, an economy along its convergence path need not display a co-integrated relationship with the economy it converges towards.
That might seem obvious, but it is not often respected in the literature, resulting in an omitted variable bias. For instance, in their analysis of monetary policy transmission, Demchuk and others (2012) or Jarocinski (2010) do not acknowledge the monetary policy regime or changes in the inflation target but also do not include foreign variables into the model. That is in stark contrast to the reality of a small open economy with open financial markets.
The value of the target for the euro area reflect the goal of inflation to be close but below 2%.
Using high-pass version of Christiano and Fitzgerald (2003) or Hodrick-Prescott high-pass filter makes little difference.
The formula for the Litterman prior is as follows. The prior mean is zero, E (Ak)ij = 0, where k is the lag, and the variance of the prior is