A Consumer Price Index adjustment overcompensates for inflation because it ignores
A)the income effect when relative prices change.
B)the substitution effect when relative prices change.
C)that some goods are inferior.
D)that the substitution effect may offset the income effect.

Question

Quizplus · Accepted Answer

The Consumer Price Index measures the overall increase in the prices of a basket of goods and services, but it assumes that consumers will continue to purchase the same basket of goods regardless of changes in relative prices. This ignores the substitution effect, which is when consumers switch to cheaper alternatives when the price of a good or service increases relative to others. By not accounting for this effect, the CPI overcompensates for inflation and may overestimate the true increase in the cost of living.

A Consumer Price Index Adjustment Overcompensates for Inflation Because It