Demand Systems with Nonstationary Prices

Relative prices are nonstationary and standard root-T inference is invalid for demand systems. But demand systems are nonlinear functions of relative prices, and standard methods for dealing with nonstationarity in linear models cannot be used. Demand system residuals are also frequently found to be highly persistent, further complicating estimation and inference. We propose a variant of the translog demand system, the NTLOG, and an associated estimator that can be applied in the presence of nonstationary prices with possibly nonstationary errors. The errors in the NTLOG can be interpreted as random utility parameters. The estimates have classical root-T limiting distributions. We also propose an explanation for the observed nonstationarity of aggregate demand errors, based on aggregation of consumers with heterogeneous preferences in a slowly changing population. Estimates using U.S. data are provided.