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The cost-of-living index with trade barriers

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    The standard cost-of-living index hinges on the assumption that there is free trade. Applying it to situations where trade barriers are present yields biased results with respect to a true cost-of-living index. Import price indices are particularly vulnerable to this bias since many of the goods included in these indices are characterised by either explicit or implicit trade barriers. In this article I generalise the cost-of-living index to also allow for barriers to trade in the form of quantity constraints. Further, I develop an upper bound index to the true cost-of-living index when trade barriers are present. The upper bound index has an intuitive interpretation and it is easy to calculate. In the case of clothing imports to Norway the mean annual upper bound cost-of-living bias due to trade barriers is between 0.9 - 1.5 percentage points. It is also shown that average prices, which is often used in the literature, is not a measure of cost-of-living and the annual underestimation of how trade liberalisation has impacted inflation from using average prices was at least 0.8 percentage points.

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    Paper provided by Research Department of Statistics Norway in its series Discussion Papers with number 751.

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    Date of creation: Sep 2013
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    Handle: RePEc:ssb:dispap:751
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    1. Diewert, W. E., 1976. "Exact and superlative index numbers," Journal of Econometrics, Elsevier, vol. 4(2), pages 115-145, May.
    2. Feenstra, Robert C, 1994. "New Product Varieties and the Measurement of International Prices," American Economic Review, American Economic Association, vol. 84(1), pages 157-77, March.
    3. Mick Silver, 2010. "The Wrongs And Rights Of Unit Value Indices," Review of Income and Wealth, International Association for Research in Income and Wealth, vol. 56(s1), pages S206-S223, 06.
    4. Steven B. Kamin & Mario Marazzi & John W. Schindler, 2006. "The Impact of Chinese Exports on Global Import Prices," Review of International Economics, Wiley Blackwell, vol. 14(2), pages 179-201, 05.
    5. Jerry Hausman, 2003. "Sources of Bias and Solutions to Bias in the Consumer Price Index," Journal of Economic Perspectives, American Economic Association, vol. 17(1), pages 23-44, Winter.
    6. Robert C. Feenstra & Clinton R. Shiells, 1996. "Bias in U.S. Import Prices and Demand," NBER Chapters, in: The Economics of New Goods, pages 249-276 National Bureau of Economic Research, Inc.
    7. W. Erwin Diewert, 1998. "Index Number Issues in the Consumer Price Index," Journal of Economic Perspectives, American Economic Association, vol. 12(1), pages 47-58, Winter.
    8. Nigel Pain & Isabell Koske & Marte Sollie, 2006. "Globalisation and Inflation in the OECD Economies," OECD Economics Department Working Papers 524, OECD Publishing.
    9. Breslaw, Jon A & Smith, J Barry, 1995. "Measuring Welfare Changes When Quantity Is Constrained," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(1), pages 95-103, January.
    10. Irene Brambilla & Amit K. Khandelwal & Peter K. Schott, 2010. "China's Experience under the Multi-Fiber Arrangement (MFA) and the Agreement on Textiles and Clothing (ATC)," NBER Chapters, in: China's Growing Role in World Trade, pages 345-387 National Bureau of Economic Research, Inc.
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