Question

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

Answer 1

Quality adjustment bias- Statisticians in government also face difficulties in assessing improvements in the quality of goods. For example, if an air-conditioner's design is so improved that it can hold 10 percent more cold air without raising energy use, then 10 percent increase in air-conditioner prices should not be viewed as inflation. There is no doubt that consumers are paying 10% more. But they also gain 10% more potential for cooling. Government statisticians, however, often fail to take into account the air-conditioner's improved quality and simply note its 10 percent price increase, the price rise will be mistakenly regarded as inflation. For some products, quality measurement (as in the case of services) is very difficult. Of example, due to the availability of 24-hour cash machines, we do not know to what extent (in percentage terms) the quality of banking service has increased. Inflation will be overestimated to the degree that the CPI does not compensate for quality improvements in the use of goods and services by people. This overestimation is known as the bias in changing performance.

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 is rising sharply for some reason, leading customers to eat only fish. As a result, 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 basic-year basket of goods and services— will record a significant increase. The rise in CPI therefore overestimates the true rise in the overall price level. 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 real inflation overestimation is known as the substitution bias.

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.

When CPI overestimates inflation, employers will earn more wages than they need to pay for rising living costs. Their real income is rising, but they feel it's the same because nominal wages are rising as quickly as the rate of inflation is increasing.