Skip to content

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

Which statement about measuring inflation with a fixed-basket consumer price index is correct?

A fixed-basket CPI may overstate inflation because it ignores substitution bias. When some prices rise faster than others, consumers shift to cheaper alternatives, but the fixed basket keeps the original quantities, so the measured cost of living rises more than the actual one.

  1. AIt cannot overstate inflation because consumers never change purchases
  2. BIt may overstate inflation because consumers substitute towards goods whose relative prices have fallen, which a fixed basket ignoresCorrect
  3. CIt always understates inflation because new products are included immediately
  4. DIt measures changes in the prices of goods bought by firms only
  5. It reflects changes in nominal GDP rather than prices

Explanation

A fixed basket ignores substitution bias: consumers switch away from goods that become relatively dearer, so the fixed-basket index tends to overstate the rise in the cost of living. The index covers consumer goods, not producer inputs, and does not measure GDP.

Did you get it right without looking?

One question tells you little. A timed set on Business activity, unemployment and inflation shows your real accuracy, how long you take and where you lose marks.

Practise Business activity, unemployment and inflationFree diagnostic mock

More Business activity, unemployment and inflation questions