This paper studies the effect of monetary policy on the Israeli consumer price index
and its components using a Factor Augmented VAR approach. We identify shocks to
two observable variables – the central bank's interest rate and the exchange rate. We
find that most prices decline in response to an increase in the interest rate, so there is
no "price puzzle". A shock to the interest rate has, at least for some time, an effect on
relative prices due to a distinct effect on partial price aggregates of the CPI.
Generally, price aggregates that are better correlated with macro factors, or that are
characterized by serial correlation in the specific shocks tend to react more to a
monetary shock. Housing and energy prices tend to react stronger to a shock in the
interest rate. A shock to the exchange rate (depreciation) has a positive effect on all
prices with prices of traded goods, energy and housing increasing more than other
prices. Our findings suggest that the main transmission channel of monetary policy to
prices is through the exchange rate.

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