The Base effect refers to the tendency of a small change from a low initial amount to the current amount which is translated into a large percentage and appears as large. To understand this we take a simple example:
We assume that government consumes Rs. 100 in 2001 and in the following years, the consumption shows the following trends.
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In this example, we note that though as compared to the Year 2001, the growth is still negative. But it appears that the growth in 2006 has jumped to 25%. This is called Base Effect. The Base effect is generally used in terms of inflation but is used almost in all important economic indicators.
Thus, 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.