Why does the substitution bias cause the consumer price index to ...

[wenmo]

Why does the substitution bias cause the consumer price index to overstate inflation and the cost of living? Why does the increase in quality bias cause the consumer price index to overstate inflation and the cost of living?
 
  What will be an ideal response?

Question 2

Which of the following is true about the Federal Reserve and its ability to prevent recessions? The Federal Reserve
 
  A) can fine tune the economy and realistically hope to keep the economy from experiencing recessions.
  B) cannot realistically fine tune the economy and has little to no effect on the magnitude and length of recessions.
  C) does not try to eliminate recessions, but instead focuses on preventing inflation.
  D) cannot realistically fine tune the economy, but seeks to keep recessions shorter and milder than they would otherwise be.

[Bigfoot1984]

Answer to Question 1

The substitution bias causes the CPI to overstate inflation and the cost of living because the CPI, being based on a fixed market basket of goods and services, implicitly assumes that consumers do not switch away from products whose prices are rising and into products whose prices are falling (or rising less). Consumers dodge some price increases by switching to other products, therefore decreasing their cost of living below what the CPI indicates.
The increase in quality bias causes the CPI to overstate inflation and the cost of living because a portion of the price increase of many goods and services is due to an increase in quality. The Bureau of Labor Statistics tries to filter out the portion of the price increase due to quality, but does not fully adjust the price increase for quality improvements.

Answer to Question 2

D

[wenmo]

YES! Correct, THANKS for helping me on my review

[shailee]

Excellent