The Relative Importance of Taste Shocks and Price Movements in the Variation of Cost-of-Living: Evidence From Scanner Data
40 Pages Posted: 27 Sep 2018
Date Written: February 1, 2018
Intertemporal consumer preference shifts, although common in modern macro-economic models as drivers of demand shocks, have important but largely unexplored implications for price index theory and thus, for empirically measured price changes. The current practice of inflation measurement basically ignores taste changes and this study aims to fill this gap. We derive a cost-of-living index in the presence of intertemporal preference shifts and show that such taste changes tend to lower the cost-of-living. Using a large barcode level dataset that covers 331 product groups and ten countries, we then uncover the importance of taste changes in explaining consumer demand shifts across close substitutes. We also analyze how measured consumer price inflation alters after allowing for taste adjustment over time and under CES preferences. To do so, we estimate the elasticity of substitution between varieties of the same good and use those to calculate goods price indexes. Our results show that the median elasticity of substitution is around 4 and find that measured average annual goods price inflation is on average about 1.1 percent lower when taking into account consumer taste shifts compared to standard goods price indexes. Our results indicate that taste changes are an important hitherto ignored factor in the measurement of cost-of-living changes.
Keywords: Inflation Measurement Bias, Cost-of-Living, Price Index, Elasticity of Substitution
JEL Classification: D11, D12, E31
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