Base Effect on Inflation


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
Inflation is calculated from a base year in which a price index is assigned the number 100. For example, if the price index in 2010 was 100 and the price index in 2011 rose to 110, the inflation rate would be 10%. If the price index rose to 115 in 2012, what would be the best way to assess inflation? On the one hand, prices have only risen 5% over the previous year, but they've risen 15% since 2010. The high inflation rate in 2011 makes the inflation rate in 2012 look relatively small and doesn't really provide an accurate picture of the level of price increases consumers are experiencing. This distortion is the base effect.
Year-on-year inflation is calculated as:
Current Rate Inflation=                (Current Price Index- Last Year’s Price Index)
                                                        ---------------------------------------------------------------  x 100
                                                                            Last Year’s Price Index

Wednesday, 06th May 2015, 08:38:19 PM

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