price and FX puzzles in many EMEs. We first confirm that a standard VAR model controlling for commodity prices as well as global demand and supply shocks produces the price and FX puzzles in EMEs (but not in advanced economies). Alternative variable orderings, identification via highfrequency external instruments, and a factor-augmented VAR, do not resolve these puzzles. Our key result is that the puzzles disappear or are mitigated when we include forward-looking variables. When we incorporate survey-based expectations from professional forecasters, consumers, and firms (as proxies for central bank forecasts) into the model, the empirical results align with theoretical predictions of monetary policy transmission in EMEs.

The critical role of expectations is confirmed through proxy VAR models, which use instrumental variables for monetary policy shocks based on single-equation policy reaction functions. Our results point to an _omitted variable_ problem: standard VAR models fail to capture future inflation developments, reflecting the high volatility of macroeconomic and financial variables in EMEs (Castelnuovo and Surico 2010). In addition, the opposite directional responses of output and inflation to monetary policy shocks (based on the mis-specified models) suggest that the omitted variables may mainly reflect the supply-driven shocks, which are more prevalent in EMEs.<sup>6</sup> Based on estimation of a model augmented with the survey data—to identify “true” monetary policy shocks in EMEs—a one percentage point contractionary monetary policy shock is followed by declines in output and prices (of around 0.9 and 0.3 percent, respectively), along with an increase in short-term interest rates (roughly 0.5-0.6 percentage point), currency appreciation (0.6 percent), and a fall in stock prices (nearly 2 percent). The significant transmission of monetary policy shocks into different financial markets (bond, stock, and currency) and macroeconomic outcomes (output and prices) are observed in a majority of EMEs.

We also find that, in many EMEs, the price puzzle disappears when the FX channel is controlled using sign restrictions in the model.<sup>7</sup> This is also consistent with the view that the cost-push (or supply-driven) channel of monetary policy transmission can contribute to the price puzzle if the FX puzzle (i.e., currency depreciation) leads to inflation. Our analysis suggests that the two puzzles in EMEs are interconnected, whereas previous literature has tended to address them separately.

> 6 Jarociński and Karadi (2020) argue that the price puzzle observed in the United States and the Euro area may reflect a bias stemming from central bank information effects. Central bank information shocks often resemble demand shocks, as output and prices tend to comove following such shocks. If similar information effects are at play in EMEs, our results might imply that central bank information in these economies conveys signals of adverse supply shocks. This would indicate that central banks in EMEs are confronted with a difficult trade-off: whether to “look through” supply shocks, or respond to them in an effort to anchor inflation expectations. Such a dilemma is well-documented in the literature, particularly in EMEs, where monetary policy responses to supply shocks tend to be more procyclical. For example, Ocampo and Ojeda-Joya (2022) find that supply shocks present significant challenges for EMEs, often forcing central banks to adopt a procyclical stance in response to temporary supply disruptions.

> 7 This is consistent with Kim and Lim (2018), who show that the price puzzle disappears in four small open economies (UK, Canada, Sweden, and Australia) once the FX puzzle is resolved through sign restrictions.

3