Final answer:
The substitution bias is believed to cause the consumer price index to overstate the true rate of inflation, as it does not reflect consumers' ability to switch to cheaper alternatives in response to price increases.
Step-by-step explanation:
The substitution bias in the context of the Consumer Price Index (CPI) refers to the issue where an inflation rate calculated using a fixed basket of goods over time is inclined to overstate the true rise in the cost of living. This occurs because the fixed basket does not account for the consumer's ability to substitute cheaper alternatives for goods whose prices have increased significantly.
Therefore, as consumers switch to less expensive goods, the actual impact of price rises on their cost of living is less than what the CPI might suggest. Consequently, the substitution bias is believed to cause the consumer price index to a. overstate the true rate of inflation.
By the early 2000s, improvements were made to reduce the substitution bias and quality/new goods bias, which now suggests that the CPI may overstate the true rise in inflation by about 0.5% per year. Though this seems minimal annually, over decades, this discrepancy can compound to a more significant value. Additionally, the CPI mainly tracks prices from physical locations as opposed to online platforms, such as Amazon, which can often offer lower prices.