Index Number Biases during Price Liberalization

When a formerly centrally planned economy frees prices and allows or compels producers to respond to market signals, conventional measures tend to severely overstate short-run output decline and inflation. The overstatement stems partly from neglect of private sector activity or belated recognition of inflation previously disguised as quality improvements. Even when individual prices and outputs are correctly measured, however, shifts in relative prices consequent to price decontrol create a serious aggregation problem. Moreover, standard indices ignore the deflationary trends in black markets. Theoretically superior indices are devised using a mixture of official and black market prices.