DP16132 Welfare and Output with Income Effects and Demand Instability

Author(s): David Rezza Baqaee, Ariel Burstein
Publication Date: May 2021
Keyword(s): Growth accounting, Hulten's theorem, Income effects, path dependence, production networks, Taste Shocks
JEL(s): E0
Programme Areas: Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16132

We provide a general non-parametric characterization of how welfare responds to changes in budget and production possibility sets when preferences are non-homothetic or subject to shocks, in both partial and general equilibrium. We generalize Hulten's theorem, which is the basis for constructing aggregate quantities, to this context. We identify a new bias in measures of real consumption that depends on the covariance of price changes and expenditure changes due to income effects or preference shocks. We apply our results to long-run and short-run phenomena. In the long-run, we show that structural transformation, if caused by income effects, is roughly twice as important for welfare than what is implied by standard measures of Baumol's cost disease. In the short-run, we show that when firms' demand shocks are correlated with their supply shocks, industry-level price and output indices are biased, and this bias does not disappear in the aggregate. Finally, we show that correlated supply and demand shifters make real GDP and aggregate TFP unreliable metrics for measuring production and productivity, and we illustrate this using the Covid-19 crisis.