Base Effect

Base effect is easy to be understood if we know how to calculate inflation.

2010 (Base year) Price level = 100 Inflation = 0%
2011 Price level = 110; Inflation = 110-100/100 * 100 = 10%
2012 Price level = 120; Inflation = 120-110/110 * 100 = 9.09%
2013 Price level = 130; Inflation = 130-120/120 * 100 = 8.33%

From 2011 to 2013; price level increase with same 10 points but inflation is decreasing.
This decreasing number in inflation is due to base effect. If price level is higher in previous year, as inflation is calculated point-to-point, this year higher price level will not show higher inflation number.

Crude example:
We know 80% inflation is too much.
base year index = 100. Inflation = 0%
base year + 1year index = 180. Inflation = 80%
Base year + 2year index = 181. Inflation = 181-180/180 *100 = 0.55%
We know price are sky rocketing, but this 0.55% is nothing compared to previous year inflation. This is known as base effect. Effect of previous year price level number on this year inflation number.

Economists use this term to control emotions, if they get higher growth number because they know previous year low numbers are responsible for higher growth rate this year.

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