Explain why inflation calculated using current year quantities as weights would produce a lower inflation figure than using previous year weights.
Gives more weight to products whose prices decrease because according to microecon a decrease in price means in increase in quantity (Substitution effect)
Inflation is measured as the percentage increase in the average price level of a basket of goods and services between two time periods. To calculate inflation, weights are assigned to different items in the basket of goods and services based on their relative importance in household spending.
When using current year quantities as weights, the basket of goods and services is based on the current spending patterns of households. This means that items that have become more popular or have seen a surge in demand will have a greater weight in the calculation. Conversely, items that have fallen out of favor or have decreased in demand will have a smaller weight.
Using previous year weights, on the other hand, the basket of goods and services is based on the spending patterns of households in the previous year. Therefore, items that were popular in the previous year would have a larger weight in the calculation, even if they were no longer in high demand.
Because the use of current year quantities as weights reflects the most recent spending patterns of households, it tends to capture changes in prices faster and more accurately than using previous year weights. This reflects the economic reality that when prices change, consumers tend to adjust their spending patterns to some extent.
As a result, using previous year weights may not accurately reflect changes in the economy, such as changing consumer preferences or the introduction of new products. As a result, using previous year weights may lead to an understatement of inflation when compared to using current year quantities as weights.
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