Does CPI Approximate Cost-of-Living?: Evidence from the Czech Republic

An original method based on an n-markets simultaneous partial equilibrium model is designed to evaluate the second order bias in the Consumer Price Index's (CPI) approximation of the Cost-of-Living (COL) and to test the statistical significance of its mean value over a variety of horizons. In the empirical application of the model I consider nine goods markets that correspond to the first strata level breakdown of the CPI in the Czech Republic for the period 1994-2000. Having evaluated the substitution bias, i.e., the difference between the growth rate of the CPI and the growth rate of the COL, I find that on a yearly basis it ranges from -0.83 to 0.51 p.p. In addition, I find that, on average, the bias statistically vanishes on the time horizon of five quarters. Different levels of inflation such as moderate (10%) and lower (2%) characterized the sample period and therefore I conclude that the derived result is robust up to moderate inflation.