Cyclical Demand Shifts and Cost of Living Inequality

This paper examines the cyclical behavior of low-income versus high-income household price indices and documents two new facts: (1) during recessions prices rise more for products purchased relatively more by low-income households (necessities); (2) the aggregate share of spending devoted to necessities is counter-cyclical. I present a mechanism where adverse macroeconomic shocks cause households to shift expenditure away from luxuries toward necessities, which leads to higher relative prices for necessities. I embed this mechanism into a quantitative model which explains 72 percent of the cyclical variation in necessity prices and 57 percent of the cyclical variation in necessity shares. The results suggest that low-income households are hit twice by recessions: once by the recession itself and again as their price index increases relative to other households.