Most economists believe there are four reasons the CPI overstates the true inflation rate. List and briefly explain these four reasons
What will be an ideal response?
1. The CPI suffers from substitution bias. When prices of certain products increase, consumers often substitute other, less expensive products for the products whose prices have gone up. The CPI does not take into account these changes in purchasing patterns.
2. The CPI suffers from a bias due to the introduction of new goods. Since the market basket is updated only every two years, new goods, whose prices often significantly decrease shortly after being introduced, may not be included in the market basket.
3. The CPI does not completely reflect changes in the quality of goods and services. For many products, quality increases over time, and the CPI does not fully adjust prices for changes in quality.
4. The CPI is subject to an outlet bias. Price data for the CPI is collected primarily from traditional retail outlets, so large discount stores are underrepresented in the sample of prices gathered for the CPI.
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What would lead an economist to conclude that Theory A is superior to Theory B?
A) Theory A predicts real-world events better than does Theory B. B) The assumptions underlying Theory A are more realistic than are the assumptions underlying Theory B. C) Theory A explains how people think, whereas Theory B only explains what they do. D) Theory A is based on the assumption that an individual typically cannot determine what is in his or her own best interest, whereas Theory B assumes that each person knows what is in his or her own best interest and acts accordingly.
The economy pictured in the figure below has a(n) ________ gap with a short-run equilibrium combination of inflation and output indicated by point ________. 
A. recessionary; B B. recessionary; C C. recessionary; A D. expansionary; A