Chapter 2

National Income Accounting

What is the National Income Accounting?
It is an official accounting system that is used to measure
economic activity.
aggregate economic activity or total output (income) of an
economy for given period of time can be represented by
GDP/ GNP.

1
2.1. The concepts of GDP and GNP
Gross domestic product (GDP)
GDP is the market value of all final goods and services
produced in a certain country in a given year.
Market value – current price/base price
Final goods and service – exclude intermediary goods
Produced in a country – with in the border of the nation,
irrespective of the owner of the recourse.
Produced in a given period when the GDP is measured
(like in 2018 )
E.g. the market value of all final goods and services
produced in Ethiopia in 2022, which are owned by
Ethiopians and foreigners is GDP of Ethiopia
2
Gross national Product (income) (GNP)
GNP is the market value of all final goods and
services produced by resources of a certain
country in a given year.
E.g. the market value of all final goods and services
produced in 2022 by Ethiopian resources (land,
labor, capital and entrepreneurship) found in
Ethiopia and abroad is Ethiopian GNP
Net factor payment (income) (NFI)
The difference between GDP and GNP is the Net
factor payment (NFI)
NFI is the difference between factor payment 3

from aboard and factor payment to abroad.

 The Concepts of Stocks and Flows
• A stock is a quantity measured at a given point
in time
• A flow is a quantity measured per unit of time.

Flow

Stock

4
• GDP is a flow variable in economics: it tells us how many dollars
are flowing around the economy’s circular flow per year
• Categorize the following variables as stock or flow
• The amount of money currently you have
• The amount of money your family send you per month
• Your money at bank
• Saving per month
• Revenue of a firm yearly
• Cost of a firm yearly
• Investment
• Wealth/capital of the economy
• Number of unemployed people
• number of people losing their jobs this year
• Accumulated government debt
5
• government debt yearly
• Government budget deficit yearly
 The Circular-Flow of Economic activity
Cost of
production
Income Market for
Factors
Labor, land, of Production Inputs for
capital, and production
enter’ship

Households Firms

Goods &
Services Goods &
Services
Market for
6
Goods
expenditure and Services Revenue
 2.2 Approaches of measuring National Income
1. Income approach
 In this approach the returns (income) to factors of
production (input) sum up together to arrive at the
GDP in a given economy per unit of time.
 It includes:-
 Wage and salary of labour
 Rent of land and physical capital
 Interest of saving and financial capital
 Profit of proprietor (sole proprietorship and
partnership firms)
 Undistributed corporate profit (corporate income
tax + dividend +retained earning)
 Indirect business tax (VAT, sales tax, excise tax)
 Depreciation of fixed capital
 Statistical discrepancy (error in measuring)
 2. Expenditure approach
• GDP is measured by aggregating expenditure made
on domestically produced final goods and services
in the product market
• It include the following components
Domestic consumer demand
(consumption expenditure --C)
Business Investment demand
(investment expenditure -- I )
Government demand
(government expenditure --G)
Foreign demand
(net foreign expenditure –NX=Expert-Import) 8
Consumption spending (C)
Personal consumption spending is goods and services
bought by households
Classified into
durable goods, e.g. TV, car, house, etc.
nondurable goods, e.g. bread, oil, etc. and
Services e.g. health care, haircut, etc.
Consumption = durable +nondurable + service
Gross Domestic private Investment (I)
• Investment is addition to the physical stock of capital
• Includes:-
Business fixed inv’t – expenditure of BSS on goods and
service that produce an other goods and services. E.g. plants,
equipments, tools, etc.
Residential inv’t – expenditure of BSS on residential
housing. 9
Inventory inv’t – investment on stored inventory to be sold
in the future.
 Government expenditure (G)
• Expenditure by any gov’t body – federal, state, local
It includes:-
1. Expenditure on goods and services e.g. provision of
public goods, police, defense and health care
service etc.
2. Salary and wages of gov’t employees
Net export (NX)
• Export is demand of foreigners for domestic
product – so it is part of domestic GDP
• Import is domestic demand for foreign product
– so it is not part of domestic GDP
• NX = EX – IM 10

In summary GDP=C+I+G+NX
3. product or value added approach
Value added: is the value of output minus the value of
the intermediate goods used to produce that output
In this approach GDP is the summation of value
added at each stages of production of all products
Summation of value added at all stages is equal to
price of final goods.
• The value of the final goods already includes the
value of the intermediate goods,
• So including price of intermediate and final goods in
GDP would be double-counting.
• The value added approach avoids the problem of
double counting.
• Example
11
Stages of production of one Value of Value
quintal of bread. txn added

Farmer grows wheat and sell to 1500 birr 1500 birr

miller
Miller converts (turns) the wheat to 1530 birr 30 birr
flour and sell to baker

The baker bake bread and sell to 1590 birr 60 birr

store owner

The store owner sells the bread to 1635 birr 45 birr

the final consumer
Final price and total value added 1635 birr 1635 birr
12
 An important and versatile concept
GDP measures:
• Value of final good and services
• total income
• total expenditure
• the sum of value-added at all stages
in the production of final goods

.
13
 Note, in measuring GDP:-
1. Transactions that are not related to current production
are not included.
Example
• Transaction of used goods and transfers of assets
• Transfer payments like social security payment,
unemployment benefit (unemployment insurance
payments), pension etc.
• Grants given to state and local government
2. Value of intermediate goods are not included in GDP if
final price is used
3. Value of non marketable goods and services are
estimated (imputed).
4. Sale of inventory is not included in GDP
5. Under ground economic activities are excluded 14

 Thus, GDP is an imperfect measure of economic activity

of a given country.
2.3. Other Social Accounts (NDP, NNP, NI, PI and DI)
 Net domestic product (NDP)
 It represent the value of total output of an economy after
net out depreciation.
NDP=GDP - depreciation.
Net National Product (NNP)
 It measures the value of total output produced by resource
of a given country after fixed capital depreciation is
deducted.
NNP=GNP – Depreciation
NNP=GDP+NFI – Depreciation
National Income (NI)
 National income measures how much everyone in the
economy has earned (excluding foreign nationals and
foreign firms).
 NI is total income earned by resource owners from current 15
production.
 Calculated in two ways
1. NNP is net amount nationals receive except it include
indirect business tax collected by the government.
NI=NNP - indirect business tax ( IBTX)
NI= GNP - Depreciation – IBTX
NI= GDP + NFI - Depreciation – IBTX
NI= NDP + NFI – IBTX
2. NI = Employees’ compensation (wage/salary)
+ Rental income
+ Net Interest
+ Proprietors’ income
+ Corporate profit

16
Personal income
PI is the amount of income that households receive
PI = National Income
− Corporate Profits
− Social Insurance Contributions
− Net Interest (public and personal)
+ Dividends
+ Government Transfers to Individuals
+ Personal Interest on Income
Disposable personal income- (DI)
It is the money spend or saved by house holds
DI = personal income
- Personal income tax and 17
- non-tax payments
DI = Consumption + Saving
Per-capita income
per-capita income measures the average income
earned per person in a given country in a specified
year.
It is calculated by dividing the GDP by its total
population.
GDP
Per  capita Income 
Population

18
2.4. Nominal and Real GDP
• GDP is the value of all final goods and services produced.
• Nominal GDP measures these values using current prices.

• Real GDP measure these values using the prices of a base

year (any past year assumed to be stable)
• Changes in nominal GDP can be due to:
changes in prices
changes in quantities of output produced
• Real GDP changes only due to change in output.
• So, Real GDP controls for inflation
• Base year is given year price
• Assume there is a country that produces two products 19
only say good A and good B in 2017 and 2018
Activity
2017 2018
P Q P Q
Good A $1 10 $2 15

Good B $10 3 $15 4

• Compute nominal GDP in 2017 and 2018

• Compute real GDP in each year using 2017 as the base
year.

20
Answers to practice problem
• Nominal GDP multiply Ps & Qs from same year
2017: $1 x 10 + $10 x 3 =$40
2018: $2 x 15 + $15 x 4 = $90
• Real GDP multiply each year’s Qs by 2017 Ps
2017: as above:$40
2018: $1 x 15 + $10 x 4 =$55
• So in real terms, GDP did not rise as much
as it would seem from nominal terms.

21
2.5 Measures of General Price level
 The general price level can be measured in three different
ways for different purposes
• GDP deflator
• Consumers’ price index
• Producers’ price index
A) The GDP deflator
• One measure of the general price level is the GDP deflator
• Also known as implicit price deflator
• It measures the current price of output relative to its price in
the base year.

Pc * Q Pc 22
GDP Deflator  
Pb * Q Pb
•.
Where:
• Pc-current price,
• Pb-base year price and
• Q-quantity produced
• GDP Deflator shows whether the price level of products
is increasing or decreasing in reference to the base year
price.
• GDP deflator as its name indicates deflates Nominal GDP
to Real GDP.
Nominal GDP
Real GDP = GDP Deflator

Example
• Assume our economy produces only coffee and wheat 23
and their prices are given in the table below. Find the
GDP deflator for the two years and interpret it.
 2010 2011
Price Quantity Price Quantity
Per KG KG
Coffee 100 3,000 120 4,000
Wheat 10 8,000 12 10,000

• Base year price is price of 2010

• GDP Deflator = Nominal GDP
Re al GDP
120x4,000  12x10,000
 2.65
100 x 4,000  10 x10,000

Interpretation: 2011 year price level is 2.65 times 24

the base year 2010 price level
2) Consumer price index (CPI)
• It represents price of a fixed basket of goods and services
purchased by a typical consumer relative to the price of
the same basket of goods and services in some base year.
• Typical consumer is average consumer.
• Used to track changes in the typical household’s cost of
living
• What are in the CPI’s Basket? Basic products like -
housing, food, beverage, transportation, medical care,
apparel, recreation , education, communication, and
others goods and services etc.

Pc1.Q1  Pc 2.Q 2  Pc3.Q3  ...

CPI 
Pb1.Q1  Pb2.Q 2  Pb3.Q3  ... 25
 3) Producer price index
• It measures the general price level of price of
typical basket of goods bought by firms relative to
the general price level at the base year.
Pc1.Q1  Pc2.Q 2  Pc3.Q3  ...
PPI 
Pb1.Q1  Pb2.Q 2  Pb3.Q3  ...

26
Difference between GDP deflator and CPI

• GDP deflator measures the price of all product bought by

consumer, producer and government that are produced in
the economy
• CPI measurers price of products consumed by the
consumer only
• GDP deflator does not include imported goods.
• CPI includes imported goods
• GDP deflator is flexible…..
27
• CPI is computed using fixed basket of good …..
 2.6 GDP and Welfare
• GDP and its derivatives enable us to make welfare
comparisons across countries
• GDP is a proxy of the consumption possibilities
• Consumption is a proxy of well-being/welfare
• GDP growth can be used as an indicator of social progress
within a society
• But it is wrong to assume that GDP or any of its common
derivatives provides a measure of social welfare, for a
number of reasons given below 28
What are the weaknesses of GDP and its derivative?
GDP is computed at market prices – which means that it
ignores externalities, particularly (but not only)
environmental ones
people do not become happier when they grow richer if
they crossed some rather low threshold in terms of income
GDP does not include a meaningful part of the economy –
household work , informal and underground economy
GDP does not include any measures of changes in natural
capital (natural resource)
GDP and its derivatives are measures of the total output of
the economy – they do not in any way account for
distributional or equity effects of it
GDP and its derivatives are all measures of income per year,
not of wealth so difficult to measure welfare 29
• Inflation
• Is a sustained rise in the general level of prices (average
price level)
• Increment sustained … it is not simply a once for all
increase in prices
• general level of price rises … price of some products may
increase, decrease or constant
• but, on average price level is increasing.
Inflation Rate (πt)
πt measures the rate at which inflation is increasing

 pt  p( t  1) 
 t  100%

 p( t  1) 
p is general price level (GDP Deflator, CPI or PPI) at 30

time t
 Cause of inflation
(i) Demand pulls factors
 Is due to rapid increase in demand for goods and
services than supply of goods and services
 Businesses respond to high demand by raising
prices to increase their profit margins.
LRAS
SRAS
p3
p2
p1
SRAD3
SRAD2
SRAD1
31
Qf
• In the long run the aggregate supply of an economy is fixed at
full employment .
• Out put can be increased only by working over time.

• But workers are willing to work over time only in the SR and
prefer leisure in the LR
• Assume the economy is producing at full employment.

• If SRAD increase how the economy respond in the SR and LR?

• Consider the following graph where

• SRAS –short run aggregate supply

• LRAS –long run aggregate supply 32

• AD—aggregate demand
 Classical AD/AS diagram

Price LRAS
Level

p3 SRAS

In the SR
p1 the
economy
can work
overtime, at
AD1 a slightly
AD higher cost
(overtime)
0 Q1 Q2 Real 33
National
Output
 Classical AD/AS diagram
LRAS
Price
Level
SRAS
In the LR,
workers are not
willing to
sacrifice Leisure
time for more
overtime work .
But still have
AD1 high wage
expectations
AD

0 Q1 Q2 Real
National 34
Output
 Why AD grows Rapidly than AS?
Classical Economists
• b/c of monetary expansion
• Increase in money supply (additional flow of money in to the
economy) increases the aggregate demand (AD)
• AD=Demand for Consumption (C) + Investment (I) +
Government expenditure (G) +net Export(NX)
• This shifts AD up ward.
• Hence it increase the general price level (inflation)
Keynesian Economists
• According to Keynesian AD increase due to increase in wage
rate (income)
• The increase in income increases AD=C+I+G+NX 35

• Such change may take place even when supply of money is

 II) Cost push (supply side) factors
1. Increase in the cost of production decreases supply
• Cost of production is price of input like labour, oil and other
raw material.
• Example
• The Sudden rise in the OPEC oil prices during 1970s due to
Arab-Israel war
2. Supply shocks - disturbance in supply position of product that
have large weight in price index commodities or key.
• Example: 36

• Other supply bottlenecks like politics etc.

 Classical AD/AS diagram
Price Level LRAS SRAS2

SRAS1

P1

P0 What will happen to the

general price level if
SRAS shifted upward?

AD

0 Q2 Q1 Real 37
National
Output
 III) Structuralists theories of inflation
• The structuralists says that the above standard theories
of inflation cannot be applied to the economies of
developing countries like Ethiopian Economy.
• Because it is based on the implicit assumption behind
the theories which the economy of LCD cannot fulfill.
Assumptions behind the other theories
• Balanced and integrated structure of the economy
• Smooth inter-sectoral flows of resources in response to
market signals
• Quick adjustment between consumption, production
(investment.)
• Smooth and free play of market forces
38
• Especially classical economists assume full
employments of resources
 Characteristics of Economy of Developing countries
• sectoral imbalances with surplus in some sector and
shortage in the other sectors.
• immobility of factors of production (input)
• wage rigidities
• highly fragmented market and high market
imperfection
• high unemployment
• As a result developing economies are characterized by
high rate of inflation with large scale of unemployment
which is a paradox.
• From these reasons standard theories of inflation and
anti inflationary policies built for developed 39

economies have little relevance to developing

economies.
 According to structuralists Causes of inflation of
developing economies are
• Main cause: the structural imbalances in the
economies
• The major structural imbalance includes:
• Food shortage (low food supply)
• Resources imbalance in different sectors
• Foreign exchange bottle necks:
• Infrastructural bottle necks

40
 Economic effect of inflation
1. It reduces real money balance
(purchasing power of money)
2. inflation increases the nominal interest rate and
cost of holding money.
Fisher’s equation r = I- П, where
I- nominal interest rate,
r-real interest rate
П expected inflation.
3. People buy more durable goods during inflation b/c
purchasing power of durable goods is non declining
4. Inflation decreases expenditure on domestic goods and
services.
5. Inflation increases uncertainties
6. Inflation redistributes wealth:
41
7. Unanticipated inflation hurts individuals with fixed
income (like pension).
• Some economist believes that moderate level of inflation
(2 to 3) percent per year is good to stimulate the
economy.
• That is a moderate level of inflation reduces real wage
and then increase level of employment (decreases
unemployment).
• When real wage rate (nominal wage minus inflation)
people want to get more wage so that supply more labor
• unanticipated inflationary shock reduces real wages and
then expands level of employment and output.
• Such relationship between nominal wage and level of
unemployment can be represented by Philips curve

42
• The Philips curve originally used to shows the relation
between wage and unemployment,
• Later it is used to relate rate of increase in price
(inflation) and unemployment

Phillips curve
Wage/
inflation

Unemployment
43
 Unemployment
• Unemployment is a situation in which able
bodied persons willing to work at prevailing wage
rate but do not able to find job
• Able bodied (15-66 age?)
• Able bodied divided into labor force and out of
labor force
Out of labor force includes
–full time student
--imprisoned
--those in mental institution
--discouraged labor 44
--unwilling to work labors
 Categories of the Adult population
• Employed - working at a paid job

• unemployed - not employed but looking for a job

• labor force - the amount of labor available for producing

goods and services; all employed plus unemployed persons
• not in the labor force not employed, not looking for work.

Two important labor force concepts

• unemployment rate percentage of the labor force that is
unemployed
• labor force participation rate is the fraction of the adult
45
population that ‘participates’ in the labor force
Continued….

unemployed
unemployment rate  x100%
labor force
labor force
Labor force participat ion rate  x100%
Adult population

46
Continued…
Exercise:
• Compute labor force statistics of U.S. adult
population by group, April 2002
• Number employed = 134.0 million
• Number unemployed = 8.6 million
• Adult population = 213.5 million
• Use the above data to calculate
• the labor force
• the number of people not in the labor force
• the unemployment rate
• the labor force participation rate

47
 Types of unemployment
1. Frictional unemployment
• Is the temporary layoff time until workers
match with jobs
• It include
• the time of searching preferable job
• time taken by information flow b/n
vacancies and unemployed
• time taken geographical movement.
• employment process,
48

•
Continued…

2. Structural unemployment
Due to structural change in dynamic economy Some
skills become obsolete and mismatch between
labour demand and supply. It includes
• Change in the structure or sectoral composition of
the economy due to technological change.
• decline of old industries production and the
emergence of new industries.
49
• Eg. Horse cart driver and Bajaj
 Continued…
3. Cyclic unemployment
• It is due to short run fluctuation of the economy

• Workers become unemployed for some period when

their job evaporates due to recession and returns to

job when there is expansion in economic activities.

50
 Continued…
• wage rigidity that set price above equilibrium
includes:
• Minimum wage law,
• Unions and collective bargaining and
• Efficiency wage argument that
• Efficiency wage argument
According to efficiency wage theory higher wages make
workers more productive.
• Enable workers to feed well and have good health
condition
• Reduce labour turnover and cost of and time of hiring
and training new workers
• High wage reduce adverse selection in labour market. It
enables selection of highly efficient labours
• reduces the problem of moral hazard that exists between 51
workers and firms. It improve workers effort with
minimum monitoring.
 Costs of unemployment
• An increase in the unemployment rate decreases the real
GDP of an economy.
• It reduces living standard
• Causes psychological distress.
• Income distribution effect; It causes inequality among
employed and unemployment workers.
Okun’s Law (Arthur Okun economist)
• Shows the inverse relation ship b/n unemployment and
RGDP
• Okun’s law says that the unemployment rate declines
when growth rate of real GDP is increasing

52
Continued…

• Okun’s Low

Percentage
change
in real GDP

Change in
unemployment 53
rate
 Business cycle
• It is the recurrent ups and downs of the economy in
the short run

• It is a regular pattern of expansion and contraction

in economic activity around trend growth.
• Business cycle shows fluctuation of all
macroeconomic variables mainly Real GDP
• Upswings and downturns of the business cycle are
gauged (measured) in terms of changes in total
54
output (real GDP)
 Continued….
Growth Trend
(potential out put)
• at full employment
Peak
Actual
output
ion
o o m, c es
s
B Re
Depression
Trough
Recovery,
Peak sion Expansion
c es
o m, Re
Bo
Depression,
Contraction Trough

Growth trend 55
 Phases of business cycle
• The line from the origin shows the trend growth,
long run change in the level of output over time
when full employment of resources are achieved.

• Expansion (Recovery or upswing):

• This phase of the economic is an increase in the volume
of goods and services produced (Real GDP increasing)

• Contraction (Downturn) :
• occurs when the volume of production declines
56
(Real GDP declining).
Continued…
Boom:
• a period of economic prosperity and growth.

• occurs when national output is rising at a rate faster than the

trend rate of growth…i.e. faster than Gov’t expects!
• High out put (Real GDP)-- Actual Real GDP > Potential Real
GDP
• High consumer spending,

• High business confidence to invest,

• High investments and profits!

• High employment (low un employment) 57

• High inflation
 Continued…
Recessions
• Is period when total output (real GDP) declines
• A phase of negative growth.
• A severe and persistent recession is called slump
• Declining aggregate demand (C, I, G and NX)
• Sharp fall in business confidence to invest &
profits
• Decrease in fixed capital investment spending
• Increased government borrowing
• High unemployment
• Reduced inflationary pressure
58
 Causes of business cycles
• What forces cause instability?
• Business cycles are likely to result from recurrent
shifts of aggregate supply and aggregate demand
curves
• Shifts in aggregate demand can be caused by
 changes in export demand,
 expectations,
 taxes,
• Shifts in aggregate supply can be caused by
 changes in costs of production
 natural disasters,
 changed tax policies,
• There are different theories on causes of business
cycle.
• Demand-side theories, such as Keynesian and 59
Monetary,
• Supply-side theories center on shifts in supply
 Continued…
Demand-Side Theories
• Keynes argued that a deficiency of spending (Demand)
tends to recession and causes unemployment
• High spending leads to boom
• Keynes advocated increasing government spending
during recession
• It increases AD toward full employment
• Monetary Theories : High money supply and
availability of credit at low cost leads to high spending
– boom
• Both Keynesians and monetarists theories emphasize
the potential of aggregate-demand shifts to alter macro
outcomes 60
 Demand-Side Theories
(a) Inadequate demand (b) Excessive demand

PRICE LEVEL
PRICE LEVEL

AS AS0

P E2

P* E0
P* E1 E0
P AD2

AD0 AD0
AD1
Q Q* REAL OUTPUT Q* Q REAL OUTPUT
61
 Continued…
Supply side Theories
• Inadequate supply can keep the economy below its
full-employment potential and cause prices to rise as
well
• Why inadequate supply?
 High rates of taxation

 heavy regulation reduce the incentive to work, to save,

and to invest.

• Increases in aggregate supply move us closer to goals 62

of price stability and full employment

 Supply-Side Theories

AS1
LRAS
AS0

E3
PRICE LEVEL

E0
P*

AD0

Q Q*
REAL OUTPUT
63