What is the definition of Base Effect in finance?

Definition

A base effect has to do with the inflation (rise in price levels) of a previous corresponding with a current year’s inflation (rise in price levels). By all implications, the low inflation rate in the corresponding period of a previous year (a rise lower in the price index) will result in a high inflation rate in the current year. Similarly, if there was a rise in the price index of the corresponding previous year it would result in a lower inflation rate in the current year. Base effects are caused by monthly or seasonal variations in the price index and they are able to produce variations in the total inflation figures.

Understanding Base Effect

Once a price index rises at a high rate in the corresponding period of the previous year, resulting in a high inflation rate, there will be a similar increase in the Price index of the current year which will lead to relatively lower inflation rates. On the contrary, if there was a low inflation rate in the corresponding period of the previous year, a little rise in the Price Index of the current year will arithmetically result in a high inflation rate.

Price levels continue to change move up and down daily and economists are more concerned with the rate at which price levels change. Therefore, inflations are reported on a month-over-month or year-over-year basis. Base effects can be caused by different factors such as changes in demand and seasonal variations.