Question

Suppose that the price of chicken rises sharply compared to the price of turkey. In response, consumers buy more turkey and less chicken than they did in the CPI base year. In this situation the CPI will tend to ______ inflation as a result of ______ bias
a) overstate; substitution
b) understate; substitution
c) accurately measure; substitution
d) overstate; quality adjustment

Answer 1

Answer:

The correct answer is option a.

Explanation:

The consumer price index or CPI is a measure to calculate the change in the price level or the rate of inflation. It calculates the changes in the price of a basket of goods generally purchased by the consumers.  

But CPI does not always accurately calculate inflation. It involves substitution bias and quality adjustment bias.  

For instance, when the price of chicken increases as compared to the price of turkey, the consumers will buy more turkey and less chicken. So the consumer expenditure will not increase as they will be substituting turkey for chicken.

But the CPI will increase with an increase in chicken price. An increase in CPI implies an increase in inflation, so inflation will be overstated.