Measuring Aggregate Price Indexes with Demand Shocks: Theory and Evidence for CES Preferences
NBER Working Paper No. 22479
We develop a new approach to measuring the cost of living for constant elasticity of substitution (CES) preferences. Our approach allows for demand shocks for individual goods (to rationalize micro data) while preserving a money-metric expenditure function (to compare the cost of living over time). We develop a new “reverse-weighting” estimator of the elasticity of substitution between goods and provide upper and lower bounds to the true parameter value. We show that abstracting from demand shocks introduces a “consumer-valuation bias,” which is analogous to the well-known “substitution bias,” and results in a substantial overestimate of the increase in the cost of living over time.
Document Object Identifier (DOI): 10.3386/w22479
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