Question

Why does substitution bias arise if we calculate the inflation rate based on a fixed basket of goods?

a) It overestimates the inflation rate
b) It underestimates the inflation rate
c) It accurately measures the inflation rate
d) It is not affected by substitution bias

Answer 1

Substitution bias overestimates inflation because it ignores consumers' ability to switch to cheaper alternatives when prices rise.

Step-by-step explanation:

Substitution bias arises when calculating the inflation rate based on a fixed basket of goods because it tends to overestimate the true rise in the cost of living. This occurs because the basket does not take into account that consumers may substitute away from goods whose prices have increased significantly. By relying on a fixed set of items, this method does not reflect consumers' ability to adjust their spending patterns in response to price changes, thereby overstating the impact of inflation on the average consumer's cost of living.