Working Paper: NBER ID: w22479
Authors: 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.
Keywords: Cost of Living; CES Preferences; Demand Shocks; Taste Shocks
JEL Codes: D11; D12; E01; E31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| taste shocks (D11) | cost of living (J30) |
| demand shocks (E39) | taste shocks (D11) |
| taste shocks (D11) | Sato-Vartia price index bias (C43) |
| Sato-Vartia price index bias (C43) | cost of living measurement (C82) |
| taste shocks (D11) | cost of living measurement (C82) |
| entry and exit of varieties + taste shocks (L15) | cost of living measurement (C82) |