The Effect of Monetary Shocks on Disaggregated Prices in a Data Rich Environment: a Bayesian FAVAR Approach

Price stability has been the foremost task of monetary policy. The information relating to the response of prices to monetary policy shocks is essential for conducting monetary policy in general and for inflation targeting of central banks in particular. Most of the published empirical studies analyze the response of an aggregate price index like CPI or a consumption deflator and their rates of change to monetary shocks. A limited number of studies that examine the effect of monetary shocks on disaggregate prices use vector auto regression models for the analysis. The results of these studies show that some disaggregated prices increase slightly in response to a contractionary monetary shock. This finding can be inconsistent with the standard theory and is referred to as the "price puzzle" in literature. There is a body of new literature (Bernanke et al. 2005, Boivin, Giannoni and Mihov 2009) that utilizes factor augmented VAR (FAVAR) approach to analyze the effect of monetary policy shocks and finds no evidence of a price puzzle. In this paper we use a Bayesian FAVAR (BFAVAR) framework to examine the impulse response function of 12 sub-categories of CPI to one standard deviation in monetary base growth rate in Iran. Our two main findings are: (1) monetary shocks have a lagged effect on disaggregated prices and most prices respond to a monetary shock with delay (2) there is a substantial difference amongst the 12 CPI sub-categories in terms of their response to an increase in monetary base growth rate. Contrary to the existing studies based on standard VAR model, and in line with FAVAR based studies, we also find that price responses don’t display a price puzzle in the case of Iran.