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Base Effect

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The base effect refers to the impact of the rise in price level (i.e. last year’s inflation) in the previous year over the corresponding rise in price levels in the current year (i.e., current inflation): if the price index had risen at a high rate in the corresponding period of the previous year leading to a high inflation rate, some of the potential rise is already factored in, therefore a similar absolute increase in the Price index in the current year will lead to a relatively lower inflation rates. On the other hand, if the inflation rate was too low in the corresponding period of the previous year, even a relatively smaller rise in the Price Index will arithmetically give a high rate of current inflation. For example:

  Price Index Inflation
  2007 2008 2009 2010 2008 2009 2010
Jan 100 120 140 160 20 16.67 14.29

The index has increased by 20 points in all the three years – 2008, 2009, 2010. However, the inflation rate (calculated on year-on-year basis) tends to decline over the three years from 20% in 2008 to 14.29% in 2010. This is because the absolute increase of 20 points in the price index in each year increases the base year price index by an equivalent amount, while the absolute increase in price index remains the same. Remember, year-on-year inflation is calculated as:

(Current Price Index – Last year’s Price Index)
Current Inflation Rate =
    * 100
Last year’s Price Index

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