Measuring Aggregate Price Indices with Taste Shocks: Theory and Evidence for CES Preferences. Issue 1 (30th September 2019)

• Record Type: Journal Article
• Authors: Redding, Stephen J; Weinstein, David E
• Is Part Of: Quarterly journal of economics. Volume 135:Issue 1(2020)
• Page Start: 503
• Page End: 560
• Publication Date: 2019-09-30
• Subjects: Economics -- Periodicals; 330.05
• DOI: 10.1093/qje/qjz031
• Languages: English
• ISSNs: 0033-5533

Abstract

Abstract: We develop an approach to measuring the cost of living for CES preferences that treats demand shocks as taste shocks that are equivalent to price shocks. In the presence of relative taste shocks, the Sato-Vartia price index is upward biased because an increase in the relative consumer taste for a variety lowers its taste-adjusted price and raises its expenditure share. By failing to allow for this association, the Sato-Vartia index underweights drops in taste-adjusted prices and overweights increases in taste-adjusted prices, leading to what we call a "taste-shock bias." We show that this bias generalizes to other invertible demand systems.