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IAI Actuarial Core Principles · Business Economics · Business activity, unemployment and inflation

Which of the following is a recognised limitation of a fixed-basket consumer price index as a measure of the cost of living?

A fixed-basket CPI ignores substitution by consumers towards goods that have become relatively cheaper, so it can overstate the true increase in the cost of living. Other weaknesses include quality changes and weights not matching individual households.

  1. AIt cannot be calculated for more than one year at a time
  2. BIt includes only the prices of capital goods bought by firms
  3. CIt ignores consumer substitution towards goods whose relative prices have fallen, so it may overstate the rise in living costsCorrect
  4. DIt measures changes in the volume of output rather than prices
  5. It is unaffected by the weights assigned to categories of spending

Explanation

A fixed basket keeps quantities constant, so when relative prices change and consumers switch to cheaper goods, the index overstates the true cost-of-living rise (substitution bias). The index covers consumer goods, measures prices not volumes, and depends heavily on weights.

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