Over the past year, beef prices rose sharply while chicken prices remained stable. A household substituted chicken for beef and maintained the same quality of diet at lower cost. The CPI basket kept the original beef and chicken quantities fixed. What does this imply about measured CPI inflation relative to the true increase in the cost of maintaining this household's living standard?
ACPI understates true inflation because it doesn't capture the full price increase for beef
BCPI accurately measures the cost of living because it tracks what households actually buy
CCPI overstates true inflation because it doesn't account for the household's ability to substitute cheaper goods
DThe two measures are identical since the household's diet quality was maintained
This is a textbook example of substitution bias. The CPI holds quantities fixed, so it computes the cost of buying the original (beef-heavy) basket even though real consumers switched to cheaper chicken. Since the household maintained its living standard at lower cost than the CPI implies, the index overstates the true increase in the cost of living. This systematic upward bias is one of the most important limitations of the CPI — it assumes households don't respond rationally to relative price changes.
Question 2 Multiple Choice
The CPI was 280 last year and is 287.4 this year. A news headline reads: 'CPI Reaches 287.4.' What does this tell you about the inflation rate?
AInflation is 287.4%
BInflation is approximately 2.6%
CInflation is 7.4 percentage points
DYou cannot determine the inflation rate from the CPI level alone
Inflation is the percentage change in the CPI, not the index level itself: (287.4 − 280) / 280 × 100 ≈ 2.64%. The headline '287.4' is the index level — it describes the cost of the basket relative to the base period, not the rate of price change. Option A confuses the index value with an inflation rate. Option C correctly identifies the absolute change (7.4) but misreports it as 'percentage points' without dividing by the prior value. CPI and inflation are frequently conflated in public discourse; the distinction is conceptually essential.
Question 3 True / False
The CPI systematically overstates the true increase in the cost of living for a typical consumer because it does not account for households switching to cheaper substitutes when prices rise.
TTrue
FFalse
Answer: True
This is the substitution bias built into CPI's fixed-basket design. When the price of one good rises relative to substitutes, rational consumers buy less of it and more of the cheaper alternative — maintaining roughly the same utility at lower cost than the fixed basket implies. By holding quantities constant, the CPI measures how much it would cost to buy the original basket rather than how much it costs to achieve the same living standard. This produces a systematic upward bias in measured inflation, estimated at roughly 0.3–0.5 percentage points per year.
Question 4 True / False
Falling prices (deflation) is typically beneficial because it increases consumers' purchasing power.
TTrue
FFalse
Answer: False
Deflation can be economically harmful in ways that rising prices are not. When prices fall, consumers may delay purchases expecting further declines, reducing aggregate demand. Firms facing falling revenues may cut wages and employment. Debtors face a real debt burden that rises as the price level falls — the nominal debt stays fixed while income and asset values decline. Japan's 'Lost Decade' is the canonical example of deflationary stagnation. A falling CPI is not straightforwardly good news.
Question 5 Short Answer
Why does the PCE deflator — the Federal Reserve's preferred inflation measure — typically run 0.2–0.5 percentage points below CPI inflation, and what does this imply about the CPI's accuracy?
Think about your answer, then reveal below.
Model answer: The PCE deflator uses a chain-weighted basket that updates spending shares each period, so it captures the substitution that consumers actually make when relative prices change. The CPI's fixed basket does not. Because the PCE reflects the cheaper goods consumers switch to as prices rise, it shows a lower rate of price increase than the CPI for the same period. This gap implies that CPI inflation is upward-biased — it overstates the true cost of maintaining consumer living standards by failing to account for substitution.
The practical consequence is significant: major government programs (Social Security, tax brackets) are indexed to CPI rather than PCE. If the Fed's preferred measure consistently runs below CPI, then cost-of-living adjustments tied to CPI grow faster than the true cost of living each year — a politically contentious implication of a seemingly technical measurement choice.