BASE EFFECT

It 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:

The index has increased by 20 points in all the three years, viz., 2008, 2009 and 2010. However, the inflation rate (calculated on ‘year-on-year’ basis) tends to decline over the three years from 20 per cent in 2008 to 14.29 per cent 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. The ‘year-on-year’ inflation is calculated by the formula :

Current Inflation Rate = [(Current Price Index – Last year’s Price Index)] ÷

Last year’s Price Index] x 100