Question

Imagine that the government statisticians who calculate the inflation rate have been updating the basic basket of goods once every 10 years, but now they decide to update it every five years. How will this change affect the amount of substitution bias and quality/new goods bias?

Answer 1

The substitution bias causes an inflation rate calculated using a fixed basket of goods over time to overstate the true rise in the cost of living because it does not take into account that people can substitute away from goods whose prices rise disproportionately.

Explanation:

When the price of a good rises, consumers tend to purchase less of it and to seek out substitutes instead.

On the other hand , if  the price of a good falls, people will tend to purchase more of it and not opt for its substitutes

This concept implies that goods with generally rising prices should tend over time to become less important in the overall basket of goods used to calculate inflation, while goods with falling prices should tend to become more important for the calculation of inflation

The quality/new goods bias causes inflation calculated using a fixed basket of goods over time to overstate the true rise in cost of living because improvements in the quality of existing goods and the invention of new goods are not taken into account.