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

Stephen J. Redding, David E. Weinstein

NBER Working Paper No. 22479
Issued in August 2016, Revised in September 2019
NBER Program(s):International Trade and Investment Program

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.

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Document Object Identifier (DOI): 10.3386/w22479

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