Question

When does the CPI overestimate and when does it underestimate the cost of living? Why?

Answer 1

Overestimates-

• If new products with high prices are supplied by firms the CPI will go up.
• when consumers show substitution bias
• Quality adjustment bias, for quality improvements in the goods and services people use, inflation will be overestimated.

Underestimates-

• When the price of oil raises the CPI rises much more than does the GDP deflator. Thus the GDP deflator underestimates true inflation.
• When relative prices of different goods keep on changing quite rapidly we get a wrong estimate of real GDP growth if we use prices of a fixed year.