CHAPTER 2

1. NATIONAL INCOME ACCOUNTING

2.1 Meaning and Approaches of National Income Accounting

National income is the sum of all individual incomes, such as the total sum of (i) all wages,
salaries, commissions and labour incomes before payment of taxes and social security
contributions. (ii) Interest income from bonds, mortgages, loans, etc. after deducting interest paid
on government debts, (iii) rental income from real property and royalties, and (iv) profit of
corporation, partnership or proprietorship, before deduction of taxes based on income.

In this connection let us see different approaches adopted by different economists to define
national income; These approaches are:
1. The Traditional approach,
2. The Keynesian approach and
3. The Modern approach

1. Traditional Approach

(i) Fisher’s definition. In the words of Fisher, “the national dividend or income consists solely
of services as received by ultimate consumers, whether from their material or from their human
environment. From this definition, fisher adopts consumption as the basis of national income.
But it has the following short comings.
- Net consumption cannot be estimated easily
- The value of services rendered by consumer durables year after year cannot be measured
- Consumer durables also keep on changing hands and therefore the change of ownership
also creates difficulties.
(ii) Marshal’s definition. According to Marshal, “The labour and capital of a country acting on
its natural resources produce annually a certain net aggregate of commodities, material and
immaterial, including services of all kind. This is the true net national income or revenue of the
country or national dividend.”

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Hence, according to Marshal;

 All types of goods and services which are produced, whether they are brought to the market
or not, are included in the national income.

 The cost of wear and tear of the machinery should be deducted from the total value of these
goods and services. The remaining could be the national income. That is why marshal
has used the term “net”.

 Income from abroad has also to be taken into account while computing the national income

But the goods and services produced in a country are so numerous that it is not easy to make out
a correct estimate of the total production. There is a difficulty of double counting which implies
that a particular commodity (as a raw material as well as finished product) may get included in
the national income.

(iii) Pigou’s definition. In the words of Pigou; “National income is that part of the objective
income, of the commodity, including of course, income derived from abroad, which can
be measured in money”. The main points of the definition are given below.

 Only goods and services exchanged for money are included in the national income.

 Income earned from investment in foreign countries has also to be counted while computing
national income.

Goods those do not exchanged for money and services rendered to one self or to family or
friends without any payment are not to be included in the national income.

2. Keynesian Approach

According to Keynes three approaches can be adopted to compute national income. These are;
A. Expenditure approach
B. Income approach, and
C. Sales minus Cost approach.

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A. Expenditure Approach

According to this approach, national income is equal to total consumption expenditure and total
investment expenditure. Systematically, it can be expressed as follows:

Y=C+I
Where
Y is national income
C is consumption expenditure and
I is investment expenditure.

B. Income approach.

According to this approach national income is the total income of all the factors of production.
Symbolically, it can be expressed as under:
Y= R+EP
Where, Y is the national income, R is the payments received by owners of factors of production
and EP represents entrepreneurial profits.

D. Sales – minus - Cost approach.

According to this approach, national income is equal to the total sale of products minus user
cost. Symbolically, it can be expressed as below:
Y=Q - C
Where, Y is the national income, Q is gross national product, and C is aggregate user cost.

3. Modern Approach ,

Modern approach has considered the concept of national income in its three aspects;
i) Product aspect
ii) Income aspect and
iii) Expenditure aspect.

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And they stress up on the existence of fundamental identity between them. Then view national
income as a flow of output, income and expenditure, when goods are produced by firms the
owners of various inputs receive income in the form of wages, profits, interest, and the remaining
is saved. The amount saved by the households is mobilized by the produces for investment
spending. Thus, there is a circular flow of production, income and expenditure. These three flows
are always equal per unit of time. Hence, total output = total income = total expenditure.

2.2 Main Features of National Income Concepts

The chief features of the concept of national income are:-
1. National income is a flow and not a stock.
2. National income, in real terms, is the flow of goods and services produced during a particular
period by an economy.
3. National income, in money terms, is the money measure of the aggregates of all goods and
services available to the nation in a particular period.
4. National income is always expressed with reference to a particular period of time (usually a
year).
5. The concept of national income is visualized as a law of national output, national income and
national expenditure. And these three flows are equal to each other.

2.3. Measuring the Performance of an Economy

The purpose of any economic activity is to satisfy human wants by providing goods like
food, shelter, equipment, and services like medical services and recreation etc. Thus, society
produces various goods and services. One of the major objectives of macroeconomics is to
introduce the method of measuring the GDP or GNP of a nation. The measure of the monetary
value of all goods and services that are produced in a country in one year is the national income
of a country. The most widely used measures of national income are Gross Domestic Product
(GDP) and Gross National Product (GNP).

Gross Domestic Product (GDP): is the market value of all final goods and services produced
by resources located within a country regardless of ownership of the resource during a year. It

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takes in to account the geographical boundary. It is the money value of annual production
(output) of a nation produced within the boundary of a given country in a market price.
Production is the activity that transforms inputs in to goods and services used for various
purposes. For instance, the shipping of goods from factories to buyers and the services provided
in a health station are the productive activities. One of the major goals of macroeconomics is to
achieve full production. When an economy is producing at its maximum capacity of production
as much as it possibly can with its available resources, full production will occur. The other
macroeconomic goal is economic growth. Economic growth refers to an increase in the level of
output or an increase in full production or full employment over time. Economic growth can be
achieved either by increasing the available resource i.e. increasing the quantities of economic
resources or improving the quality of economic resources through education or on job training or
improving technology (technological advancement). For instance, improving the quality of
factors of production like labor by giving on job training or education will allow productive
capacity to grow. You remember from previous courses that economic growth would occur when
the production possibilities curve shifts to the right. Therefore, when an economic growth occurs,
more consumer and capital goods can be produced and the production possibility curve shifts to
the right (out ward).

Gross National Product (GNP): is the market value of all final goods and services produced by
resources owned by citizens of a country during a year. It measure the money value of all
finished goods and services produced in an economy in a given year. In general, GNP measures
the money value of output produced by every citizen of that country regardless of whether he/she
is currently living in the country while GDP measures the money value of output produced by
everyone living within the borders of the country. In order to avoid double counting, in this type
of measurement, only finished goods and services that are ready for sale to their final users
should be included. Otherwise, if we include products in a stage of production or intermediate
products (products that may be used as input for other production process) then production will
be overstated. GNP measures the value of goods and services produced not goods and services
sold in a given year. Hence, second hand sales are not included in the GNP because these goods
were previously counted in GNP.

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Here under is the explanation of the three possible approaches to measure gross national product
(GNP) or gross domestic product (GDP).

1. The Output Approach

This is the method of measuring GNP by adding up the market value (monetary value) of output
of all firms in the country. In this method of measuring GNP, it is important to include only final
goods and services in order to avoid double counting. Double counting will arise when the output
of some firms are used as the inputs of other firms but there are two possible ways of avoiding
double counting. These are: taking only the value of final goods and services and taking the sum
of the value added by all firms at different stages of production.

Value of final goods and services

When we say final goods and services, we mean goods and services, which are being purchased
for final use and not for resale or further processing. On the other hand, intermediate goods refer
to purchase or goods and services for resale or for further processing or manufacturing.
Therefore, to avoid double counting, the sale of final goods should be included and the sale of
intermediate goods should be excluded from GNP because the value of final goods already
includes the value of intermediate goods involved in their production.

The sum of the value added methods

To avoid double counting, it is also necessary to use value added method. Value added is the
market value of firm’s output less the value of the inputs purchased from others. Thus, by
summing the values added by all firms in the economy, GNP can be determined.

2. Expenditure Approach

To determine GNP using expenditure approach, we must add up all types of spending of final
goods and services. Expenditures can be categorized into 4 groups depending on who buys the
goods or services. We examine these categories as follows:

 Personal consumption expenditure (C)

 Gross private investment (I)

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  Government purchase of goods and services (G)
 Net export (NE)

Personal consumption expenditure (C)

Personal consumption expenditure includes expenditures by households on durable goods like

cars, refrigerators, TV etc, non-durable goods like bread, beer, pencil, tea etc and for services
like barber, restaurant, lawyer, mechanics etc.

Gross private Domestic investment (I)

It refers to all investment spending by business firms. Investment includes all purchases of
machinery, equipment and tools by business enterprise, all construction like building of a new
factory and change in inventories. Investment also includes residential construction. This is
because like factories, residential house are income-earning assets. That means they can be
rented to yield money income as a return.

Since GNP measures the value of output produced in a given year, in order to get accurate
measures of GNP, we must include the market value of inventories, which are produced in the
given year but not sold in the same year. If we exclude inventories from GNP, then it would
understate the given year’s total production.

If business firms have more goods on their shelves, then the economy has produced more than it
has consumed during the given year. This increase in inventories should be added to GNP. On
the other hand, if there is a reduction in inventory, then the economy sells output, which exceeds
current production. This reduction in inventory must be subtracted from GNP, because GNP
measures the value of current year’s output. However, investment does not include the transfer of
money or assets. It does not also include the buying of stocks and bonds, because such purchases
transfer the ownership of existing assets. In general, the resale of existing assets will not be
included in investments.

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Therefore, gross private domestic investment include the production of all investment goods,
which include the additions to the stock of capital and replacing the machinery, equipment and
building used up in the current year production.

In short, gross private investment includes added investment and depreciation. If we take only
the added investment, which has occurred in the current year, then we get net private investment.

Net private investment = Gross private investment – depreciation

Where depreciation is the allowance made for tear and wear out of capital.

From the above relationship, you can observe the following points:

 When gross investment exceeds depreciation or when net investment is positive, the
economy is expanding (growing) i.e. its stock of capital is growing.
 When gross investment and depreciation are equal or when net investment is zero, the
economy is static economy i.e. it is producing enough capital to replace what is
consumed in producing the given year’s output
 Whenever gross investment is less than depreciation or whenever net investment is
negative i.e. when the economy uses up more capital than it produces, the economy will
be disinvesting (declining). In other words, when depreciation exceeds gross investment,
the nation’s stock of capital is less at the end of the year than at the beginning of the year.

Example:

The following example will enable you to identify the difference between net investment and
gross investment.

Suppose in 2015, a certain economy produced about 10 billion birr worth of capital
goods. However, in the process of producing, the economy used up 3 billion birr worth of
machinery and equipment. Determine the net private investment

Solution

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 Since 10 billion Birr worth of capital goods private investment and 3 billion Birr worth of
machinery and equipment are the value of the capital used up in the production processes
(depreciation) in 2015, the difference between the two (10 billion – 3 billion = 7 billion
birr) is the net private investment of the given economy in 2015.

Government purchases of goods and services (G)

It includes all government spending at different layers of the government like at federal, state and
local levels on final goods and services. However, it excludes all government transfer payments
because such payments don’t reflect current production.

Net export (NE)

Net export (NE) = Export –Import

Spending by foreigners in a certain country may contribute just as spending by the citizens.
Hence, we have to add the value of net export in determining GNP. On the other hand, the value
of import (produced abroad) do not reflect productive activity of a country, thus should be
subtracted. Net export is the difference between the amounts by which foreigner spending on a
certain country and the amount of citizens spending on foreign country. In other words, net
export is the difference between export and import

From the above relationship, you can observe the following points:

 When export exceeds import, net export is positive.

 When export is equal to import, net export is zero.
 When export is less than import, net export is negative

For example, foreign countries buy 5 billion dollar worth of capital from country X (i.e. export)
and country X buys 4 billion dollar worth of capital from foreign countries (i.e. import) in a
given year, net export of country X will be 1 billion dollar (5 billion dollar – 4 billion dollar).

In general, the value of gross domestic product of any economy will be given as:

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 GDP = C + Ig + G + NE

A country may own resources in foreign country, which leads to a flow of income from abroad
in to the country, denoted by I1, similarly resources owned by foreigners in a country may lead to
outflow of income to abroad from the country, denoted by I 0 the difference between income
inflow (I1) and income outflow (I0) is known as net factor income from abroad.

Net I = I1 – I0

Hence, the relationship between GNP and GDP is given as:

GNP = GDP + net income from abroad

GNP = GDP + (I1 – I0 )

You can observe the following relationship:

 when I1 > I0 , GNP exceeds GDP

 when I1 = I0 , GNP equals GDP
 when I1 < I0 , GNP is less than GDP

Example:

This example will help you to develop your skill of computing GNP and/or GDP using the
following hypothetical data of a certain country answer the questions below.

Value in billion birr

1. Capital consumption allowance (depreciation) 1220
2. Personal consumption expenditure 6320
3. Government spending on goods and services 5000
4. Transfer payment 650
5. Income earned by foreigners in the country 500
6. Net investment 5780
7. Income earned by citizens abroad 800
8. Export 500

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9. Import 750

Using the appropriate method, calculate GDP and GNP

Solution

GDP= C + Ig + G + NE
= C + net investment + depreciation + G + NE
Where GDP = Gross domestic product
C= personal consumption expenditure
Ig = Gross private investment
G= Government purchases of goods and services
NE = net export
GDP = 6320 + 5780+ 1220+5000+500-750
GDP = 18070 billion birr
GNP = GDP + (I1 – I0)
= GDP + (I1 – I0)
= 18070+800 -500
GDP = 18370 billion birr

How was this 18370 billion birr of expenditure of the hypothetical country allocated or
distributed as income. It would be simple if we could say that total expenditures on the
economy’s yearly output flow to households as wages, rent , interest, and profit incomes but the
picture is complicated by two non-income charges against the value of total output. These are
consumption of fixed capital (depreciation) and indirect business taxes. In the coming section,
you will see the methods of measuring the performance of an economy using income approach.

3. The Income Approach

According to this method, payments received by all citizens of the country that have contributed
in the current year production are added to get gross national product. Hence, gross national

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product using income approach includes compensation to employees, rent, interest, profit,
depreciation and indirect business tax and subsides.

Compensation to employees (C)

It includes wages and salaries and their supplements like employer’s contributions in social
security, pension, health and welfare funds, which are paid by business firms and government to
suppliers of labor.

Rents (R) are payment to households that supply property resources.

Interest (I) refers to payments by private firms to household which supply capital. However,
interest payment made by government is excluded.

Profit (Π) includes proprietors’ income (profit of unincorporated business) and corporate profit.
Proprietors’ income refers to the net income of sole proprietors, partnerships and corporations.
While corporate profits include corporate income taxes (part flow to government), dividends
(part divided to stock holders) that are payment flow to households and undistributed corporate
profits that are retained as corporate earnings.

Depreciation (capital consumption allowance) (D)

The annual payment, which estimates the amount of capital equipment used up in each year’s
production, is called depreciation. It represents a portion of GNP that must be used to replace the
machinery and equipment used up in the production process.

Indirect business tax (IBT)

The government imposes indirect taxes on business firms. These taxes are treated as cost of
production. Therefore, business firms add these taxes to the prices of the products they sell.
Indirect business tax includes sales taxes, excise taxes and custom duties etc.

Therefore, GDP and GNP using income approaches are given as follows:

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 GDP = C+ R+ I+ II+ D+ IBT – subsidy
GNP=GDP + net income from abroad

Example:

By doing the following example, you will be able to compute GNP and/or GDP using income
approach. Given the following hypothetical data of a certain country, answer the questions
below;

Types of income Amount (in billion birr)

Compensation of employees 10,800
Proprietor’s income 400
Rental income 600
Corporate profit 4000
Net interest 170
Deprecation 1600
Indirect business taxes 200
Income earned by foreigners in the country 500
Income earned by citizens abroad 800

1. Compute GDP using income approach

2. Compute GNP using income approach

Solution

1. GDP using income approach is determined as follows:

GDP = C + R +I + II + D + IBT
GDP = 10800+ 600+ 170 + 400 + 4000 + 1600 + 200 = 17770 billion birr
2. GNP = GDP + Net income from abroad
GNP = 17770 + 800 – 500 = 18070 billion birr

Nominal and Real Gross National product

GNP is given in two forms. These are Nominal GNP and real GNP. Nominal GNP (NGNP)
measures the money value of all finished goods and services according to price during the year
in which the goods and service are produced. That means it measures the value of current

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 production in terms of current prices. This type of measurement can be influenced by both
changes in the price and production (output).

Real GNP (RGNP) measures the money value of all finished goods and services using a
certain base year price. Real GNP is nominal GNP adjusted to eliminate inflation. It is
preferable than nominal GNP because it indicates the state of the economy and it is important
for analyzing production condition. While measuring an economy using nominal GNP,
inflation distorts what actually happened to production. Thus, evaluating the economy using
nominal GNP would be misleading.

In order to calculate real GNP, it is necessary to have measure of price changes over the years,
i.e. price index, using one year as a base year. This price index or GNP deflator provides the
mechanism for converting nominal GNP to real GNP.

Real GNP = Nominal GNP for the given year X 100

For the given year GNP deflator for that year

Thus, real GNP for a given year is found by dividing that year’s nominal GNP by that year’s
GNP deflator and then multiplying by 100.

Other Social Accounts

In addition to GNP, there are also other social accounts, which can be derived from GNP and has
equal importance. Hence, in this section we will see additional social accounts.

These are:

 Net national Product (NNP)

 National Income (NI)
 Personal income (PI)
 Personal disposable income (PDI)

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 Net National product (NNP)

GNP as a measure of the economy’s annual output may have defect because it fails to take into
account capital consumption allowance, which is necessary to replace the capital goods used up
in that year’s production. Hence, net national product is a more accurate measure of economy’s
annual output than gross national product because it takes capital consumption allowance or
depreciation in to account and it is given as:

Net National product =Gross National product – Capital consumption allowance

(NNP) (GNP) (D)

National income (NI)

National income is the income earned by economic resource (input) suppliers for their
contributions of land, labour, capital and entrepreneurial ability, which involved in the given
year’s production activity. It measure the income received by resource supplier for their
contributions to current production. However, from the components of NNP, indirect business
tax, which is collected by the government, does not reflect the productive contributions of
economic resources because government contributes nothing directly to the production in return
to the indirect business tax. Hence, to get the national income, we must subtract indirect business
tax from net national product.
National income = Net National product – indirect business tax + subsidies
(NI) (NNP) (IBT) (S)

Personal income (PI)

Part of national income like social security contribution (payroll taxes), and corporate income
taxes are not actually received by individuals. Therefore, they should be subtracted from the
national income. On the other hand, transfer payment, which include welfare payments, veterans’
payments, unemployment compensation, are not currently earned. Therefore, in order to get
personal income (PI) which is a measure of income received by individuals, we must subtract

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from national income those types of income which are earned but not received and add those
types of income which are received but not currently earned.

Personal income (PI) =National income (NI) - social security contribution (SSC)
-corporate profits -Net interest + transfer payment + Dividend + personal interest
income

Personal Disposable Income (PDI)

Personal disposal income is the difference between personal income and personal income taxes.
It is the amount of income which households divided it as saving and consumption. Personal
taxes include personal income taxes, personal property taxes and inheritance taxes.

Personal Disposable Income = personal income – personal income taxes

(PDI) (PI) (PIT)

2.4 Nominal GDP versus Real GDP

Economists use the rules just described to compute GDP, which values the economy’s total
output of goods and services. But is GDP a good measure of economic well-being? Consider
once again the economy that produces only apples and oranges. In this economy GDP is the sum
of the value of all the apples produced and the value of all the oranges produced. That is, Notice
that GDP can increase either because prices rise or because quantities rise.
It is easy to see that GDP computed this way is not a good gauge of economic well-being. That
is, this measure does not accurately reflect how well the economy can satisfy the demands of
households, firms, and the government. If all prices doubled without any change in quantities,
GDP would double. Yet it would be misleading to say that the economy’s ability to satisfy
demands has doubled, because the quantity of every good produced remains the same.
Economists call the value of goods and services measured at current prices nominalGDP.
A better measure of economic well-being would tally the economy’s output of goods and
services and would not be influenced by changes in prices. For this purpose, economists use real
GDP, which is the value of goods and services measured using a constant set of prices. That is,

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real GDP shows what would have happened to expenditure on output if quantities had changed
but prices had not.
To see how real GDP is computed, imagine we wanted to compare output in 2011 and output in
2012 in our apple-and-orange economy. We could begin by choosing a set of prices, called base-
year prices, such as the prices that prevailed in 2011. Goods and services are then added up
using these base-year prices to value the different goods in both years. Real GDP for 2011 would
be:
Real GDP = (2011 Price of Apples *2011 Quantity of Apples) +(2011 Price of Oranges *2011
Quantity of Oranges).
Similarly, real GDP in 2012 would be: Real GDP = (2011 Price of Apples *2012 Quantity of
Apples) + (2011 Price of Oranges *2012 Quantity of Oranges).
And real GDP in 2013 would be: Real GDP =(2011 Price of Apples *2013 Quantity of Apples) +
(2011 Price of Oranges *2013 Quantity of Oranges).
Notice that 2011 prices are used to compute real GDP for all three years. Because the prices are
held constant, real GDP varies from year to year only if the quantities produced vary. Because a
society’s ability to provide economic satisfaction for its members ultimately depends on the
quantities of goods and services produced, real GDP provides a better measure of economic
well-being than nominal GDP.

2.5The GDP Deflator and the consumer price index

2.5.1 The GDP Deflator
From nominal GDP and real GDP we can compute a third statistic: the GDP deflator. The GDP
deflator, also called the implicit price deflator for GDP, is defined as the ratio of nominal GDP
to real GDP:
GDP Deflator =Nominal GDP/Real GDP
.The GDP deflator reflects what’s happening to the overall level of prices in the economy.
To better understand this, consider again an economy with only one good, i.e bread
The total amount of birr spent on bread in that year will be, P *Q. Real GDP is the number of
loaves of bread produced in that year times the price of bread in some base year,(P base *Q). The

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GDP deflator is the price of bread in that year relative to the price of bread in the base year, (P/P
base).
The definition of the GDP deflator allows us to separate nominal GDP into two parts: one part
measures quantities (real GDP) and the other measures prices (the GDP deflator). That is,
Nominal GDP=Real GDP *GDP Deflator.
Nominal GDP measures the current dollar value of the output of the economy. Real GDP
measures output valued at constant prices. The GDP deflator measures the price of output
relative to its price in the base year.
This new chain-weighted measure of real GDP is better than the more traditional measure
because it ensures that the prices used to compute real GDP are never far out of date. For most
purposes, however, the differences are not important. It turns out that the two measures of real
GDP are highly correlated with each other. The reason for this close association is that most
relative prices change slowly over time. Thus, both measures of real GDP reflect the same thing:
economy-wide changes in the production of goods and services.
2.5.2 The Consumer Price Index (CPI) (
Measuring the Cost of living: A dollar today doesn’t buy as much as it did twenty years ago.
The cost of almost everything has gone up. This increase in the overall level of prices is called
inflation, and it is one of the primary concerns of economists and policymakers.
The Price of a Basket of Goods: The most commonly used measure of the level of prices is the
consumer price index (CPI). It can be computing by collecting the prices of thousands of goods
and services. Just as GDP turns the quantities of many goods and services into a single number
measuring the value of production, the CPI turns the prices of many goods and services into a
single index measuring the overall level of prices.
How should economists aggregate the many prices in the economy into a single index that
reliably measures the price level? They could simply compute an average of all prices. Yet this
approach would treat all goods and services equally.
Because people buy more chicken than caviar, the price of chicken should have a greater weight
in the CPI than the price of caviar. The CPI is the price of this basket of goods and services
relative to the price of the same basket in some base year.

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For example, suppose that the typical consumer buys 5 apples and 2 oranges every month. Then
the basket of goods consists of 5 apples and 2 oranges, and the CPI is

CPI = . (5 XCurrent Price of Apples) (2 XCurrent Price of Oranges)

(5 X2012 Price of Apples) (2 X2012 Price of Oranges)

In this CPI, 2012 is the base year. The index tells us how much it costs now to buy 5 apples and
2 oranges relative to how much it cost to buy the same basket of fruit in 2013.
The consumer price index is the most closely watched index of prices, but it is not the only such
index. Another is the producer price index, which measures the price of a typical basket of goods
bought by firms rather than consumers. In addition to these overall price indexes, there are also
price indexes for specific types of goods, such as food, housing, and energy.
Another statistic, sometimes called core inflation, measures the increase in price of a consumer
basket that excludes food and energy products. Because food and energy prices exhibit
substantial short-run volatility, core inflation is sometimes viewed as a better gauge of ongoing
inflation trends.
2.5.3 The CPI versus the GDP Deflator
The GDP deflator is the implicit price deflator for GDP, which is the ratio of nominal GDP to
real GDP. The GDP deflator and the CPI give somewhat different information about what’s
happening to the overall level of prices in the economy. There are three key differences between
the two measures.
The first difference is that the GDP deflator measures the prices of all goods and services
produced, whereas the CPI measures the prices of only the goods and services bought by
consumers. Thus, an increase in the price of goods bought only by firms or the government will
show up in the GDP deflator but not in the CPI.
The second difference is that the GDP deflator includes only those goods produced domestically.
Imported goods are not part of GDP and do not show up in the GDP deflator. Hence, an increase
in the price of a Toyota made in Japan and sold in this country affects the CPI, because the
Toyota is bought by consumers, but it does not affect the GDP deflator.
The third and most subtle difference results from the way the two measures aggregate the many
prices in the economy. The CPI assigns fixed weights to the prices of different goods, whereas

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the GDP deflator assigns changing weights. In other words, the CPI is computed using a fixed
basket of goods, whereas the
GDP deflator allows the basket of goods to change over time as the composition of GDP
changes. The following example shows how these approaches differ.
Suppose that major frosts destroy the nation’s orange crop. The quantity of oranges produced
falls to zero, and the price of the few oranges that remain on grocers’ shelves is driven sky-high.
Because oranges are no longer part of GDP, the increase in the price of oranges does not show
up in the GDP deflator. But because the CPI is computed with a fixed basket of goods that
includes oranges, the increase in the price of oranges causes a substantial rise in the CPI.

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