Question

Suppose manufacturers introduce a new model car to replace a car currently included in the CPI basket. The price of the new car is 10 percent higher than the discontinued model, but the new car has additional safety features and amenities. In this situation the CPI will tend to ______ inflation as a result of ______ bias.A. overstate; substitutionB. understate; quality adjustmentC. accurately measure; substitutionD. overstate; quality adjustment

Answer 1

Answer:

The correct answer is option D.

Explanation:

The consumer price index is a tool to measure inflation in the economy. It measures the change in price level through a basket of goods generally purchased by the households. It does not include change in quality.  

It is measured as

CPI =  

$\frac{Cost\ of\ Market\ Basket\ in\ Base\ Year}{ Cost\ of\ Market\ Basket\ in\ Given\ Year} \ \times\ 100$

In the given example, the price of the car is increasing but the quality is improving as well. Since the CPI does not include quality, the inflation rate will be overstated.