Previous Year Question
A rapid increase in the rate of inflation is sometimes attributed to the “Base Effect”. What is the “Base Effect”?
It is the impact of a drastic deficiency in supply due to the failure of crops.
It is the impact of a surge in demand due to rapid economic growth.
It is the impact of the price levels of the previous year on the calculation of the inflation rate.
None of the statements (a), (b) and (c) given above is correct in this context.
Correct Answer: C
Detailed Solution
The Base Effect is a statistical effect arising because the current inflation rate is calculated by comparing the present Price Index with the Price Index of an earlier period.
Year-on-Year inflation is generally calculated as:
Therefore, even when the current Price Index remains the same, the calculated inflation rate can change according to the level of the previous year’s base.
Example of a Low Base Effect
Suppose the Price Index in the previous year was unusually low at 95, while the current Index is 110:
If the previous year’s Price Index had instead been 100, the same current Index of 110 would produce:
The current Index is 110 in both cases, but inflation appears higher when the previous year’s base is lower. This is called a Low Base Effect.
High Base Effect
If the previous year’s Price Index was unusually high, Year-on-Year inflation may appear low even though the current price level remains elevated.
For example:
This does not mean that goods have become cheaper. It only means that the rate at which prices are increasing has declined.
Inflation, Disinflation and Deflation
Inflation: The general price level is increasing.
Disinflation: Prices continue to rise, but at a slower rate.
Deflation: The general price level is actually declining.
A decline in inflation caused by the Base Effect does not automatically amount to Deflation.
Why are the other options incorrect?
A crop failure may produce supply-side inflation, while rapid economic growth may generate demand-pull inflation. These are real economic causes of inflation, but neither defines the Base Effect.
The Base Effect concerns the statistical influence of the comparison period rather than a current change in demand or supply.