Suppose there are only two goods (Good A and Good B)and the average person buys 4 of Good A in a year and 3 of Good B. If, in the base year, the Price of Good A is $5 and the Price of Good B is $10, and in the next year the Price of Good A is $4 and the Price of Good B is $12, one problem with the CPI way of calculating inflation is

Question

Quizplus · Accepted Answer

The CPI assumes that people will continue to buy the same amount of each good even if its price changes. However, people are likely to substitute a cheaper good for a more expensive one, to some extent. Therefore, the CPI overstates the degree of inflation by not taking into account the possibility of substitution between goods. In this example, if the prices of Good A and B change, people might buy less of Good B and more of Good A, which would moderate the increase in the cost of living.

Suppose There Are Only Two Goods (Good a and Good