Question

The CPI for all consumers is comonly used as an index to adjust wages, pensions, and other contracts as a COLA (Cost of Living Adjustment). What is one situation for which the CPI may not be the best COLA to use?

Answer 1

There can be many situations in which the CPI is not useful enough as a cost of living adjustment. There are fixed number of items in the construction of CPI and introduction of new items does not change the basket. In this way CPI does not include the new goods that are being produced in the economy and so it tends to negate the effects of introduction of new goods. There is a substitution bias whereby the consumers switch to cheaper products when they are preferred products are now expensive. Under these situations CPI may not reflect the actual consumption basket and it often tend to overstate the actual inflation.