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Measuring Aggregate Price Indexes with Taste Shocks: Theory and Evidence for CES Preferences

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  • Stephen J. Redding
  • David E. Weinstein

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 term a “taste-shock bias.” We show that this bias generalizes to other invertible demand systems.

Suggested Citation

  • Stephen J. Redding & David E. Weinstein, 2016. "Measuring Aggregate Price Indexes with Taste Shocks: Theory and Evidence for CES Preferences," NBER Working Papers 22479, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:22479
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    More about this item

    JEL classification:

    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
    • D12 - Microeconomics - - Household Behavior - - - Consumer Economics: Empirical Analysis
    • E01 - Macroeconomics and Monetary Economics - - General - - - Measurement and Data on National Income and Product Accounts and Wealth; Environmental Accounts
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation

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