Question

The consumer price index (CPI) is calculated a. using a fixed basket of goods and, therefore, will tend to understate inflation. b. using a fixed basket of goods and, therefore, will tend to overstate inflation. c. using a constantly changing basket of goods and, therefore, will tend to understate inflation. d. using a constantly changing basket of goods and, therefore, will tend to overstate inflation.

Answer 1

Answer: b. using a fixed basket of goods and, therefore, will tend to overstate inflation.

Explanation:

CPI uses a fixed basket of goods each year and measure inflation by monitoring the changes in this basket over several years/ periods.

This has the tendency to overstate inflation however, due to three(3) main reasons: Substitution bias, Quality bias and New product bias.

With substitution bias, the CPI does not take into account that when products increase in price, people will substitute them for lower priced goods. Quality bias means that CPI does not account for change in quality. New Product bias means that CPI does not account for new and better products as it uses a fixed basket.

Put together these three can cause CPI to overstate inflation by as much as 1% sometimes.