CHAPTER TWO

THE NATIONAL INCOME ACCOUNTING

National income accounting concepts have been designed to measure the overallproduction
performance of the economy. By comparing the national income accountsover a period of time,
we can plot the long-run course that the economy has beenfollowing; the growth or stagnation of
the economy will show up in the national incomeaccounts. It also provides a basis for the
formulation and application of public policiesdesigned to improve the performance of the
economy.

It is generally agreed that the best available indicator of an economy’s health (wellbeing)is its
total annual output of goods and services, or the economy’s aggregate output. Thebasic social
accounting measures of the total output of goods and services are GrossDomestic Product (GDP)
and Gross National Product (GNP).

GDP is defined as the total monetary value of all final goods and services produced inthe
territories (within the boundary) of the economy in a given year.The GDP is an attempt to
summarize all economic activity over a period of time in terms of a single number; it is a
measure of the economy’s total output and of total income.

GNP is defined as the total monetary value of all final goods & services produced bycitizens of
the country in a given year. Thus, GDP and GNP are related as follows:

GNP = GDP + Net Factor Income (NFI)

But NFI = Factor income generated from citizens (all resources) living abroad minusfactor
income flowing out by foreigners living in host country.

In simple words, GDP is territorial while GNP is national.

GDP is more commonly taken as the basic and single most important measure of a nation’s
output as compared toGNP. This is because:

1. GDP is easier to measure, since data on net foreign earnings are usually poor,

2. GDP is the better measure of the job-creating potential of an economy than is GNP,and

3. It makes international comparisons easier, as most countries use GDP.

Otherwise, it is possible to use any of the two measures.

GDP is a monetary measure that includes only the value of final goods and services andignores
transactions involving intermediate goods (in order to avoid double counting). Toavoid double
counting, national income accountants are careful to calculate only thevalue added by each firm.

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Value added is the market value of a firm’s output less the value of the inputs, which ithas
purchased from others.

GDP also excludes two non-productive transactions i.e,

1) Purely financial transactions, which include:

- Public transfer payments because recipients make no

- Private transfer payments contribution to current

- Buying and selling of securities production in return for them

2) Second hand sales because such sales either reflect no current production, or theyinvolve
double counting.

2.1. Approaches to Measuring GDP

There are three approaches to measuring GDP.

 Product or value added approach

 Expenditure approach
 Income approach

Each approach gives a different perspective on the economy. However, the fundamentalprinciple
underlying national income accounting is that, except for problems such as incompleteor misreported
data, all three approaches give identical measurements of the amount of currenteconomic activity.

2.1.1 Product (Output) Approach or Value Added Approach

In this method, GDP can be obtained either by taking the market value of final goods and
services or by taking the value added at each stage of production. The value added of
anyproducer is the value of its output minus the value of the inputs it purchases from other
producers. Consider the hypothetical data below:

Stages of Production Sales value of product Value added

Firm A, sheep ranch $ 60 $ 60
Firm B, Wool processor 100 40
Firm C, suit manufacturer 125 25
Firm D, clothing wholesaler 175 50
Firm E, clothing retailer 250 75
sales value $ 710
Value added (total income) $250

Thus, by calculating and summing the values added by all firms (sectors) in the economy, we can
determine the GDP, that is, monetary value of the total output.
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2.1.2 Expenditure Approach

All final goods produced in an economy are purchased either by the three domesticsectors:
households, government and business enterprises; or by foreign nations. Thus, todetermine GDP
through this approach, one must add up all types of spending on finishedgoods and services by
these sectors. That is;

GDP = Personal consumption expenditure (C) by households+ Gross private domestic

investment (I) by businesses+Government purchases of goods and services (G) by
government+ Net exports (export – import) (Xn) by foreign sector

Personal consumption expenditure (C) entails expenditures by households on

durable consumer goods (goods that last only a short time, such as food and
clothing), non-durable consumer goods (goods that last a long time such as cars,
TVs) and consumer expenditures for services.
Gross domestic private investment (I) (purchase of machinery and equipment, all
constructions, and changes in inventories) includes replacement and added
investment i.e., replacement investment which implies depreciation (capital used
up), D, and added investment that is known as net investment (In). Thus, I = D+
In. In general, investment is divided into threesubcategories:business fixed
investment (purchase of new plant and equipment by firms), residential fixed
investment (purchase of new housing), and inventory investment (the changes in
firms’ inventories of goods).
Government purchases (G) include all government (federal, state and local)
spending on the finished products of businesses and all direct purchases of
resources by government.
Net exports (Xn): is the amount by which foreign spending on domestic goods and
services (Exports = X) exceeds domestic spending on foreign goods and services
(import = M). In other word, net exports represent the net expenditure from abroad
on our goods and services, whichprovides income for domestic producers. It can
be positive or negative.

Thus, GDP = C + I + G + Xn

2.1.3 Income Approach

This year’s GDP can also be determined (other than by adding up all that is spent to buythis
year’s total output) by summing up all the incomes derived from the production of this year’s
total output.

This approach measures GDP in terms of income earned. It is the sum of all incomesreceived
from all factors of production which contribute to the production process plustwo additional non-
factor payments. The main income categories are:

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  Compensation of employees: This comprises wages and salaries paid
bygovernments and businesses = W + S
 Rents (r): Consists of income payments received by households and
businesses,which supply property resources.
 Interest (i): comprises items such as the net interest payments households receiveon
saving deposits, certificate of deposits (CDs) and corporate bonds.
 Proprietor’s income or profit (ΠP) - is net income of sole proprietorships
andpartnerships (or income of unincorporated businesses).
 Corporate Profits (ΠC) - may be divided into three:
 may be collected as corporate income taxes.
 may be distributed as dividends (to stockholders).
 may be retained as undistributed corporate profits.

That is, IIC = corporate income tax + dividend + undistributed corporate profits.

Note: Total Profits (Π) =Πp +Πc

* Adding employees’ compensation, rents, interests, Πp&Πc, and NFI we get a country’s
National Income (NI): NI= (W+S)+r+i+Π+NFI.

 Indirect Business Taxes (IBT): Which firms treat as costs of production, andtherefore,
add to the prices of the products they sell. E.g. sales tax, excise tax,business property
tax, license fee.
 Consumption of fixed capital (depreciation, D): The annual charge, whichestimates
the amount of capital equipment used up in each year’s production, iscalled
Depreciation.

Therefore, GDP = (W+S) + r + i + Π+ D+ IBT

2.2. Other Social Accounts (GNP, NNP, NI, PI and DI)

1) GNP = GDP + NFI

2) Net National Product (NNP): Is GNP adjusted for depreciation changes. It is derivedby
subtracting the capital consumption allowance, which measures replacementinvestment, from
GNP. Because the depreciation of capital is a cost of producing the output of the economy,
subtractingdepreciation shows the net result of economic activity.That is,NNP = GNP – D

3) National Income (NI): Measures the income earned by resource suppliers for
theircontributions (of land, labour, capital, and entrepreneurial ability), which go into theyear’s
net production. The only component of NNP that does not reflect the currentproductive
contributions of economic resources is IBT. Thus,NI = NNP – IBT; (IBT= Indirect business tax).

4) Personal Income (PI): is income received by households.

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PI = NI (income earned)

-Social security contribution

-Corporate income taxes Since such incomes are not
-Undisturbed corporate profits (retained income).actually received by households
and should be deducted

+Government Transfers to individuals

+Dividends because it is received by households
+Personal Interest Income though not currently earned

5) Disposable Income (DI): the income individuals have to spend or save after paymentof taxes.
It is simply personal income less personal tax and non-tax
payments (PT).Thus, DI = PI – PT

Exercise: Below is a list of domestic output and national income figures for a givenyear. All
figures are in billions of Birr.

S.No. Income/Expenditure Components Value in Current Prices

1 Personal Consumption expenditure 245
2 Net factor income from abroad 4
3 Transfer payments to households 12
4 Rents 18
5 Consumption of fixed capital (D) 27
6 Social Security contributions 20
7 Interest 13
8 Proprietor’s income 33
9 Net exports 11
10 Dividends 16
11 Compensation of employees 223
12 Indirect Business Taxes 18
13 Undistributed Corporate Profits 21
14 Personal Taxes 26
15 Corporate income taxes 19
16 Government purchases 72
17 Net private domestic investment 33
18 Personal saving 28

Using the above data, determine:

a) GDP by both the expenditures and income methods.

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b) GNP and NNP.

c) NI in two ways:

i) by adding up the types of income which make up NI, and

ii)by making the required additions and/or subtractions from NNP.

d) PI, and

e) DI

2.3. Nominal versus Real GDP

Nominal GDP: Represents the market value of all final goods and services at current prices. But
the value of different years’ GDPs can be usefully compared only if the valueof money (price)
itself doesn’t change. Inflation (or deflation) complicates GDP because GDP is a price
timesquantity figure. The change in either the quantity of output or thelevel of prices will affect
the size of GDP since GDP equals the sum of PiQi. But it is thequantity of goods & services
produced & distributed to households which affects theirstandard of living, not the price. If, for
instance, all prices doubled without any change inquantities, GDP would double. Yet it would be
misleading to say that the economy’sability to satisfy demands has doubled, because the quantity
of every good producedremains the same. Thus, to compare GDPs of different periods (or to see
differences inproduction activities or economic performance of a nation) Nominal GDP must
beadjusted for price level changes. In other words, real GDP should be used. Real(constant-
Birr) GDP measures each year’s output in terms of the prices prevailed in aselected base year
as opposed to Nominal (Current Birr) GDP, which measures eachyear’s output valued in terms
of the prices prevailing in that year.

For instances, the following table shows market-basket (or collection) of output and
corresponding prices for a group of selected years. We assume that 2001 prices are used as a
selected base year prices. Hence, nominal GDP and real GDP for all years computed
accordingly.

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 year Quantity of goods Unit Prices of goods Nominal GDP Real GDP
2000 12 20,000 240,000 264,000
2001 13 22,000 286,000 286,000
2002 13 24,000 312,000 286,000
2003 14 24,000 336,000 308,000
2004 16 26,000 416,000 352,000

Unlike nominal GDP which could changes from year to year either because of physical output of
goods changes or market prices change, real GDP varies from year to year only if the quantities
produced varyas the prices are held constant. Because asociety’s ability to provide economic
satisfaction for its members ultimately depends on thequantities of goods and services produced,
real GDP provides a better measure of economic wellbeingthan nominal GDP.

2.4. The GDP Deflator and the Consumer Price Index: cost of measuring living

Economists measure changes in the price level, or inflation, using a price index. There are three
indexes to measure the overall level of prices in the economy: GDP deflator, consumer price
index and producer price index.

2.4.1 The GDP Deflator

From nominal GDP and real GDP we can compute a third statistic: the GDP deflator. TheGDP
deflator, also called the implicit price deflator of GDP, is defined as the ratio ofnominal GDP to
real GDP (times 100).

Nominal GDP
GDP Deflator= X 100
Real GDP

The definition of the GDP deflator allows us to separate nominal GDP into two parts: onepart
measures quantities (real GDP) and the other measures prices (the GDP deflator).

That is, Nominal GD = Real GDPxGDP deflator


Measures the current measure output at measures the price of output
monetary value of the constant prices. relative to its price in the base year.
economy’s output.

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Therefore,GDP deflator reflects what is happening to the overall level of prices in the economy.

2.4.2 The Consumer Price Index (CPI)

Price Index: Measures the combined price of a particular collection of goods andservices in a
specific period relative to the combined price of an identical group of goodsand services in a
reference period.

The CPI is the most commonly used measure of the level of prices (or of the cost ofliving). Just
as GDP turns the quantities of many goods and services into a single numbermeasuring the value
of production, the CPI turns the prices of many goods and servicesinto a single index measuring
the overall level of prices.

CPI= Cost of a Market Basket of Products at Current Pricesx 100

Cost of the Same Basket of Products at Base Year Prices

Note that CPI = 100 for the selected base year.

The CPI differs from the GDP deflator in three main ways:

 The GDP deflator measures the prices of a much wider (all) group of goods and services
than CPI does. The CPI measures only the prices of goods and services bought by
consumers. Thus, an increase in the prices of goods and services bought by firms or the
government will show up in the GDP deflator but not in the CPI.
 The CPI measures the cost of a given basket of goods and services, which is the same
from year to year. The basket of goods and services included in the GDP deflator,
however, differs from year to year, depending on what is produced in the economy in
each year. In other words, the CPI assigns fixed weights to the different goods, whereas
the GDP deflator assigns changing weights.
 The CPI directly includes prices of imports, whereas the GDP deflator includes
only prices of products produced domestically.

Neither of these two price indices is clearly superior to the other in measuring
the cost of living. Moreover, the difference between them is usually not large in
practice. Thus, the CPI is also used to deflate nominal GDP so as to arrive at the
real GDP.

Nominal GDP NGDP

Real GDP= = X 100
CPI /100 CPI

The consumer price index is the most closely watched index of prices, butit is not the only such
index.Another is the producer price index, which measuresthe price of a typical basket of goods
bought by firms rather than consumers.

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2.5. GDP and Welfare

GDP has some limitations in gauging the social wellbeing of the people in a nation. Thisis
mainly because of:

 Non-market transactions (such as preparing meals, making household repairs and

handling own financial affairs in homes) are not included; non-monetary
economies will be underestimated.
 It doesn’t include the underground economy (black market) transactions –
transactionsthat are never reported to tax and other government authorities
because either thetransactions involve illegal goods and services or the people
want to evade taxes.
 It ignores the quality aspect of goods and services.
 It does not consider the cost of environmental damage, which could decrease the
quality of lives, among others.
 The satisfaction that one gets from recreational activities and other uses of his/her
leisure time are not accounted for.
 It is based on estimations and thus may not accurately reflect even the
transactions it explicitly intended to measure.

2.6. The Business Cycle

Business cycle is the term used to describe the fluctuations in aggregate production asmeasured
by the ups and downs of real GDP. It is the non-regular pattern of expansion(recovery) and
contraction (recession) in economic activity around the path of trendgrowth. The trend path of
GDP is the path GDP would take if factors of production werefully employed.

Over time, real GDP changes for two reasons:

 More resources become available: the size of population increases, land is improved
for cultivation, the stock of knowledge increases as new goods and new methods of
production are invented and introduced. This allows the economy to produce more
goods and services, resulting in a rising trend level of output.
 Factors (resources) are not fully employed all the time. Even in cases where there is
no open (observable) unemployment, there might be disguised unemployment
(underemployment) of resources. Similarly, we have times when resources are
employed to work overtime and used for several shifts. This implies that output
fluctuations over time.

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 Peak Trend Level/

Con
Output (Real

on cessio Potential/
(R e
n)

trac Full-

nsio

y
Actua

over
ti Emp’tOutput
GDP)

Expa

(Rec
Outp

n
Troug ut

)
h Time
GDP doesn’t grow at its trend rate. Rather it fluctuates irregularly around the trend,showing
business cycle patterns from trough (output and employment bottom-out at their lowest level)
through recovery (economy’s level of output and employment expands towards full
employment) to peak (economy is at full employment and national output is almost at full
capacity, inflation also present), and then frompeak through recession and back to trough. These
movements are not regular in timing orin size. Nor is the trend growth rate constant; it varies
with changes in technicalknowledge and the growth of supplies of factors of production.
Deviations of output fromtrend are referred to as the output gap.

Output Gap = Potential Output – Actual Output

The output gap measures the gap between the output the economy could produce at
fullemployment given the existing resources and technology and the output it actuallyproduces.
Output gap grows during a recession. The gap declines and ultimately evenbecomes negative
during an expansion. A negative gap means that there is overemployment, overtime for workers,
and more than the usual rate of utilization ofmachinery.

Often a long expansion reduces unemployment too much, causes inflationary pressures,and
therefore triggers policies to fight inflation – and such policies usually createrecessions.

2.7. Unemployment and Inflation

2.7.1 Unemployment

The total population of a country can be categorized into two:

the working-age population and

thepopulation outside the working-age (which is country-specific).

Those in the working-age could also be divided into two: currently active and currently
inactive.Moreover, the people who are currently active in the working- age category are either

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employed or unemployed (actively seeking a job). Hence, the summation of employed and
unemployed people gives us the labor force of an economy.

A person is said to be unemployed if he/she is in theworking-age, available for work, actively

seeking work, but doesn’t have one (during thecensus). The unemployment rate measures the
ratio of the number of unemployed to thetotal number of the labor force (x 100%). That is,

Number of Unemployed
Unemployment rate= X 100
Number of Labor Force

There are different types of unemployment:

1) Frictional Unemployment: is the usual amount of unemployment resulting from people

who have left jobs that didn’t work out and are searching for new employment, or people
who are either entering or reentering the labor force to search for a job.
2) Structural Unemployment: is unemployment resulting from permanent shifts in the
pattern of demand for goods and services or from changes in technology such as
automation or computerization. To regain employment, workers in the pool of
structurally unemployed have to find jobs in other industries or locations, or learn new
skills.
3) Cyclical Unemployment: is the amount of unemployment resulting from declines in real
GDP during periods of contraction (recession), or in any period when the economy fails
to operate at its potential.

The total amount of unemployment is the sum of frictional, structural, and

cyclical unemployment’s. Frictional and structural unemployment’s result
from natural and, perhaps, unavoidable occurrences in a dynamic economy;
and, most often, one is cannot be distinguished from the other. Cyclical
unemployment, however, is the result of imbalances between aggregate
purchases and the aggregate production corresponding to full employment.
Thus, cyclical unemployment receives the greatest amount of attention since
it is viewed as controllable.

Full employment does not mean zero unemployment. It refers to the

situation that occurswhen the actual rate of unemployment is no more than
the natural rate of unemployment.The time, effort and transaction costs
required to find a new job guarantee that there willalways be some
unemployed workers looking for jobs. The natural rate of unemploymentis
the percentage of the labor force that can normally be expected to be
unemployed forthe reasons other than cyclical fluctuations in real GDP. In
other words, the natural rateof unemployment is the sum of the frictional
and structural unemployment’s expectedover some period (usually a year).

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An economy in which the actual unemployment rate is less than the natural
rate ofunemployment is termed as an overheated economy. In such a case
the economy canproduce more than the potential real GDP, implying that the
economy’s capacity outputexceeds the potential real GDP. However, most
economists believe that this couldn’thappen for long periods without
consequences that impair its future performance andultimately cause actual
real GDP to decline to its potential level.

Cyclical Unemployment (which is usually characterized by layoffs –

temporarysuspensions of employment without pay) tends to increase during
contractions(recessions). This negative relationship between changes in real
GDP and changes in theunemployment rate is known as Okun’s law.

The problem of unemployment is of great concern to economists because it

has costs.The main costs of unemployment are:

1. Output is lost (GDP falls) because the economy is not at full

employment.
2. Distortional impact – unemployment usually hits poorer people harder
than the richand this increases the concern about the problem (as income
inequality rises).
3. The unemployed may have more leisure when not working. But this
benefit is morethan offset by the costs to the society since:
 The value placed on that leisure is small as much of it is
unwanted leisure, and
 The government loses income tax revenue and thus job loss hurts
the societythan the individual.

2.7.2 Inflation

Inflation is the upward movement in the general price level for an

aggregate of goodsand services produced in a nation. When inflation exists,
the purchasing power of anation‘s currency declines over time. On the other
hand, Deflation is the opposite of inflation (it is a downward movement in the
general price level).

Annual rates of inflation are measured by the percentage change in a price index from one year
to the other. The percentage change in the CPI is the most commonly used measure of inflation,
followed by the percentage change in the GDP deflator.

CPIt−CPIt −1
Infla tion rate at Period t= X 100
CPIt −1

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Measured this way, inflation is an average of the increases in the prices of all goods andservices
in the CPI of a market basket. The greater the weight attached to an item in theCPI, the greater
the impact of a change in its price on the CPI (and thus on the rate ofinflation).

Types of inflation:
Pure Inflation: refers to a condition that occurs when the prices of all goods
rise by thesame percentage over the year. If an economy experienced pure
inflation, there would beno changes in the relative prices of goods. Thus,
pure inflation does not provideconsumers with any incentive to substitute
one good with the other in their budget, nordoes it change the profitability
for sellers of one good rather than another.
Hyper Inflation: inflation at very high rates prevailing for at least one year.
Disinflation: a sharp reduction in the annual rate of inflation. When
disinflation occurs the price level continues to rise, but its rate of increase
is sharply reduced.
Effects of Inflation:
Inflation can result in a redistribution of income and wealth from creditors todebtors. As
a result of inflation, debtors can pay back loans in currency units thathave less purchasing
power than what they borrowed. It can also harm savers, who,in effect are creditors
because the purchasing power of currency units in savingsdecreases as a result of
inflation.
Hyperinflation seriously harms the functioning of the economy by causing creditmarkets
to collapse and by wiping out the purchasing power of accumulatedsavings.
Actions taken in anticipation of inflation can adversely affect the performance ofthe
economy. When buyers and sellers try to anticipate, they base their economicdecisions, in
part, on the gains and losses they expect to get/incur. This can affect thesupply of and the
demand for particular goods and services thereby distortingmarket prices.
Anticipated inflation can distort consumer choices by causing buyers to purchasegoods
now that they might otherwise prefer to purchase in the future.

Expansionary aggregate demand policies tend to produce inflation, unless they

occurwhen the economy is at high levels of unemployment.

Inflation could be demand-pull inflation (where high aggregate demand is responsiblefor it) or
cost-push inflation (where adverse supply shocks are typically events that pushup the costs of
production).

2.7.3 The Phillips Curve

The Phillips curve describes an empirical relationship between inflation andunemployment: the
higher the rate of unemployment, the lower the rate of inflation. Thecurve suggests that less

13
unemployment can always be attained by incurring more inflationand vice versa. In other words,
the curve suggests a trade-off between inflation andunemployment.

The Phillips
Inflation Rate

Curve

0
Unemployment Rate

The trade-offs between inflation and unemployment always have to be taken into account when
the government is considering whether and how it can increase growth and employment or
reduce inflation.

This trade-off between unemployment and inflation holds in the short run. (However, there are
disagreements among economists.) In the long run, there is no trade-off worth speaking about
between inflation and unemployment. In the long run, the unemployment rate is basically
independent of the long run inflation rate.

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