Question

In what 2 ways does the consumer price index overestimate the rate of inflation

Answer 1

Substitution Bias- CPI as a true measure of inflation is another problem. This problem arises when consumers display replacement bias. Suppose consumers like mutton and fish are nearly equal and eat equal quantities of each in the base year. But the price of mutton increases dramatically for some reason, which encourages consumers to eat only fish. Consequently, the cost of living is not greatly affected by mutton's price rise.

However, when the price of mutton rises sharply, the CPI, which measures the causes of buying the base-year basket of goods and services, will record a substantial increase. The rise in CPI thus overestimates the real increase in the overall price rate. The issue arises because the CPI is based on the assumption that, over time, customers buy a fixed basket of goods. It does not take note of the fact that consumers often replace more expensive goods or services with.cheaper. This cause of true inflation overestimation is known as the replacement bias.

Introduction of New Products- When firms sell new products at high prices, the CPI will go up. This is another reason why inflation is estimated by the CPI over. If CPI overestimates true inflation, then increases in real atypical family income (which is the true purchasing power indicator) are underestimated correspondingly. Industrial workers ' wages are often linked, as measured by the CPI, to the cost of living indices in order to protect workers ' living standards in the organized sector. If CPI overestimates inflation, workers will receive more wages than they need to compensate for rising living costs. Their real income is rising, but they think it's the same because nominal wages are rising as fast as the level of prices is rising.