The CPI tends to overstate inflation because of the following biases:
- Substitution bias - when the price of a product in the consumer basket increases substantially, consumers tend to substitute lower-priced alternatives. For example, if a freeze in Florida causes the price of oranges to skyrocket, consumers may substitute Texas grapefruits for Florida oranges. Since the CPI is a fixed-weight price index, it would not accurately predict the impact of the price increase on the consumer's budget.
- Quality bias - over time, technological advances increase the life and usefulness of products. For example, the useful life of automobile tires increased substantially over the past few decades, decreasing the tire cost on a per mile basis, but the CPI does not reflect such improvements.
- New product bias - new products are not introduced into the index until they become commonplace, so the dramatic price decreases often associated with new technology products are not reflected in the index.
- Outlet bias - the consumer shift to new outlets such as wholesale clubs and online retailers is not well-represented by the CPI.
Some economists estimate that such biases overstate the CPI by about 1% per year.
The U.S. Department of Labor has responded to these biases by more frequently changing the base period when the items in the index and their weights are adjusted. Also, the government now is quicker to add new products to the CPI basket and has made quality adjustments to the index.
The Business Cycle
Economic growth is not a steady phenomenon; rather, it tends to exhibit a pattern as follows:
- an expansion of above-average growth
- a peak
- a contraction of below-average growth
- a trough or low-point
The troughs then are followed by periods of expansion and the cycle generally repeats, though not in a regular manner. These fluctuations in economic growth are known as the business cycle and are depicted conceptually in the following diagram:
