Final answer:
Substitution bias occurs when measuring inflation with a fixed basket of goods because it overstates the cost of living by not considering consumer substitution towards cheaper goods. The BLS has implemented methods to account for substitution and updates the basket of goods more regularly to improve CPI accuracy.
Step-by-step explanation:
Substitution bias arises when calculating the inflation rate using a fixed basket of goods because it fails to reflect consumer behavior accurately. As prices rise, consumers tend to substitute away from more expensive goods towards cheaper alternatives. This behavior mitigates the impact of price increases on the consumer's cost of living. If the inflation rate is calculated based on a fixed basket of goods without allowing for substitution, it tends to overstate the true rise in the cost of living. The basket of goods used to measure inflation should ideally be updated regularly to reflect changes in consumer preferences and the availability of new goods, ensuring a more accurate calculation.
The Bureau of Labor Statistics (BLS) has recognized the need to account for substitution between goods and quality/new goods biases. By the early 2000s, alternative mathematical methods were employed to calculate the Consumer Price Index (CPI), allowing for some substitution and more frequent updates to the basket of goods. The BLS also conducts studies to adjust for quality improvements in goods like computers, taking into account aspects such as speed, memory, and screen size. Despite these efforts, determining the proper adjustments remains a challenge and is often debated among economists.