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CHAPTER TWO
NATIONAL INCOME ACCOUNTING

National income accounting concepts have been designed to measure the overall production
performance of the economy. By comparing the national income accounts over a period of time,
we can plot the long-run course that the economy has been following; the growth or stagnation of
the economy will show up in the national income accounts. It also provides a basis for the
formulation & application of public policies designed to improve the performance of the
economy.
It is generally agreed that the best available indicator of an economy’s health (well being) is its
total annual output of goods & services, or the economy’s aggregate output. The basic social
accounting measures of the total output of goods & services are Gross Domestic Product (GDP)
and Gross National Product (GNP).

2.1. The concept of GDP and GNP

Definition:GDP is defined as the total market value of all final goods and services produced in
the territories (within the boundary) of the economy in a given year.
GNP is defined as the total monetary value of final goods & services produced by citizens 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 living abroad minus factor income flowing out
by foreignersliving in host country.
GDP is more commonly taken as the basic measure of a nation’s output as compared to GNP.
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 the economy than is GNP, and
3. It makes international comparisons easier, as most countries use GDP
GDP is a monetary measure that includes only the market value of final goods & services and
ignores transactions involving intermediate goods (in order to avoid double counting). To avoid
double counting national income accountants are careful to calculate only the value added by
each firm.
 Value added is the market value of a firm’s output less the value of the inputs, which it
has purchased from others.
GDP also excludes two non-productive transactions i.e,
1) Purely financial transactions - which include:
- Public transfer payments because recipients make
- Private transfer payments no contribution to current
- Buying & selling of securities production in return for them.
2) Second hand sales- because such sales either reflect no current production or they involve
doublecounting
2.2.Approaches of Measuring GDP
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1. Product (Output) Approach or Value Added Approach:

In this method, GDP can be obtained either by taking the market value of final goods & services
or by taking the value added at each stage of production.
Consider the hypothetical data below:

Sales value of Value

Stages of Production product 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
Total 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, market value of total output.GDP can also be determined either by
adding up all that is spent on this year’s total output or by summing up all the incomes derived
from the production of this year’s output. That is,
The amount spent on this The money income derived from the
year’s total output. production of this year’s output.
=

(Expenditure-side) (Income-side)

2. Expenditure Approach
All final goods produced in an economy are purchased either by the three domestic sectors:
households, government and business enterprises or by foreign nations. Thus, to determine GDP
through this approach, one must add up all types of spending on finished goods & services by
these sectors. That is;
GDP = Personal consumption expenditure(C)by households
+ Gross private domestic investment(I) by businesses
+Government purchases of goods & services(G) by government
+ Net exports (export - import)(Xn) by foreign sector
Thus, GDP=C+I+G+NX
 Personal consumption expenditure (C) entails expenditures by households on durable
consumer goods, non-durable consumer goods & consumer expenditures for services.
 Gross investment (I) (purchase of machinery & equipment, all constructions, and changes in
inventories) includes replacement & added investment i.e., replacement investment implies
depreciation (capital used up), D, and added investment that is known as net investment (In).
Thus, I=D+ In. The relationship between gross investment & depreciation provides a good
indicator of whether our economy is expanding, static or declining.
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 When gross investment (I) exceeds depreciation (D) i.e., positive net investment
(In>0), the economy is expanding (since its productive capacity or stock of capital
goods is growing.)
 A stationary or static economy reflects the situation in which I and D are equal (orIn=
0).
 The unhappy case of declining economy arises whenever I is less than D, i.e., when the
economy uses up more capital in a year than it manages to produce.
 Government expenditures (G) include all government (federal, state and local) spending on
the finished products of businesses & all direct purchases of resources by government.
 Net exports (Xn): is the amount by which foreign spending on domestic goods and services
(Exports) exceeds domestic spending on foreign goods & services (import). It can be
positive or negative.

3. Income Approach
This year’s GDP can also be determined (other than by adding up all that is spent to buy this
year’s total output) by summing up all the incomes derived from the production of this year’s
total output. It measures GDP in terms of income earned. It is the sum of all incomes received
from all factors of production that contribute to the production process plus two additional non-
factor payments. The main income categories are:
a) Compensation of employees: This comprises wages & salaries paid by governments
and businesses = W + S
b) Rents (r): Consists of income payments received by households& businesses, which
supply property resources.
c) Interest (i): comprises items such as the net interest payments households receive on
saving deposits, certificate of deposits (CDs) and corporate bonds.
d) Proprietor’s Incomeor profit (ΠP) - is net income of sole proprietorships and
partnerships (or income of unincorporated businesses).
e) Corporate Profits (ΠC) - may be divided into three:
- They may be collected as corporate income taxes
- They may be distributed as dividends (to stockholders)
- They may be retained as undistributed corporate profits.
Thus, Corporate profit (ΠC) = corporate income tax + dividend + undistributed corporate
profits.
Note: Total Profits (Π) =Πp +Πc
Adding employee compensation, rents, interests,Πp&Πc, andNFI we get a country’s National
Income (NI).
f) Indirect Business Taxes (IBT):Which firms treat as costs of production & therefore add to
the prices of the products they sell.
E.g. Sales tax, excise tax, business property tax, license fee.
g) Consumption of fixed capital (depreciation-D): The annual charge, which estimates
the amount of capital equipment used up in each year’s production, is called depreciation.
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Therefore, GDP=(W+S) + R + I + Π+IBT+D

2.3. 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 derived by
subtracting the capital consumption allowance, which measures replacement investment, from
GNP.
That is, NNP=GNP-D
3)National Income (NI): Measures the income earned by resource suppliers for their
contributions of land, labor, capital, and entrepreneurial ability, which go into the year’s net
production. The only component of NNP that does not reflect the current productive
contributions of economic resources is IBT. Thus, NI = NNP - IBT
4) Personal Income (PI): is income received by households.
PI = NI (income earned)
-Social security contribution
- Corporate income taxes are not actually received by hhs& should be deducted.
- Undisturbed corporate profits
+ Transfer payments is received but not currently earned.
5) Disposable Income (DI): the income individuals have to spend or save after payment of
taxes. It is simply personal income less personal tax and non-tax payments (PT). DI =
PI -PT
Example: Below is a list of domestic output and national income figures for a given year. All
figures are in billions.
S.N. Income/Expenditure components Value in current prices (In
millions)
1 Personal Consumption expenditure $245
2 Net factor income from abroad 4
3 Transfer payments 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 Corporate profits 56
17 Government purchases 72
18 Net private domestic investment 33
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19 Personal saving 28
Using the above data,
a) Determine GDP by both the expenditures & income methods. Then, determine GNP &NNP.
b) Determine NI in two ways:
i) By adding up the types of income which make up NI, &
ii) By making the required additions or subtractions from NNP.
c) Obtain PI, &
d) Obtain DI

2.4. Nominal versus Real GDP

Nominal GDP: Represents the market value of all final goods and services at current prices.
Nominal (Current-Birr) GDP measures each year’s output valued in terms of the prices
prevailing in that year.But, the value of different years’ GDPs can be usefully compared only if
the value of money (price) itself doesn’t change.
Real (Constant-Birr) GDP measures each year’s output in terms of the prices, which prevailed
in a selected base year asopposed toNominal (Current Birr) GDP, which measures each year’s
output valued in terms of the prices prevailing in that year.
2.5. The GDP Deflator and the Consumer Price Index
A. 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 of GDP, is defined as the ratio of nominal GDP to
real GDP (times 100).
GDP deflator = (Nominal GDP / Real GDP) x 100.
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 x GDP deflator

Measures the current measures output at measures the price of

monetary value of the constant prices output relative to its
economy’s output price in the base year.
Thus, GDP deflator reflects what is happening to the overall level of prices in the economy.
B. The Consumer Price Index (CPI)
Price Index: Measures the combined price of a particular collection of Goods & services in a
specific period relative to the combined price of an identical group of goods & services in a
reference period. The CPI is the most commonly used measure of the level of prices (or cost of
living). 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.
Cost of a market basket of
In a given year, CPI = products at current prices x 100
Cost of the same market basket of
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Products at base year prices

The CPI differs from the GDP deflator in three main ways.
1. The GDP deflator measures the prices of a much wider (all) group of goods and services
than CPI does. The CPI measures the prices of 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.
2. 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 prices of different goods, whereas the GDP
deflator assigns changing weights.
3. 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.
Real GDP = Nominal GDP x 100 = NGDPx 100
CPI PI
Example:
Yea Units of output Price of output Price Index Unadjusted or Adjusted or
r per unit (in $) (Year 1 = 100) Nominal GDP Real GDP
1 500 $10 (10/10)100=100 $5000 $5000/1.00=$5,000
2 700 20 (20/10)100=200 14000 14000/2.00=$7,000
3 800 25 250 20000 $8,000
4 1000 30 300 30000 $10,000
5 1100 28 280 30800 $11,000

2.5..5 GDP and Welfare

GDP has some limitations in gauging the social well being of the people in a nation. This is
mainly because:
A) It is difficult to include 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.
B) It doesn’t include the under ground economy (Black Market) transactions – transactions
that are never reported to tax and other government authorities because either the
transactions involve illegal goods and services or the people want to evade taxes.
C) It ignores the quality aspect of goods & services.
D) It does not consider the cost of environmental damage, which coulddecrease the quality
of lives, among others.
E) Ignores the satisfaction that one gets from recreational activities and other uses of leisure
time.

.2.6. PROBLEMS OF ECONOMIC ACTIVITIES

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1. The Business Cycle

Business cycle is the term used to describe the fluctuations in aggregate production as measured
by the ups and downs of real GDP. It is the more or less regular pattern of expansion (recovery)
and contraction (recession) in economic activity around the path of trend growth. The trend path
of GDP is the path GDP would take if factors of production were fully employed. Over time,
real GDP changes for two reasons:
1. 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.
2. Factors are not fully employed all the time:Even in cases where there is no open
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 output fluctuations over time.

GDP doesn’t grow at its trend rate. Rather it fluctuates irregularly around the trend, showing
business cycle patterns from trough, recovery to peak, and then from peak through recession and
back to trough. These movements are not regular in timing or in size. Nor is the trend growth
rate constant; it varies with changes in technical knowledge and the growth of supplies of factors
of production. Deviations of output from trend are referred to as the output gap.
OUPUT GAP = Potential Output – Actual Output
The output gap measures the gap between actual output and the output the economy could
produce at full employment given the existing resources and technology. Output gap grows
during a recession. The gap declines and ultimately even becomes negative during an expansion.
A negative gap means that there is over employment, overtime for workers, and more than the
usual rate of utilization of machinery.Often a long expansion reduces unemployment too much,
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causes inflationary pressures, and therefore, triggers policies to flight inflation – and such
policies usually create recessions.

2. Unemployment
The total population of a country can be categorized into two as the working age population and
outside the working age (which is country specific). Those in the working age could also be
divided into two: currently active and currently inactive.The people in the working age category
who are either employed or actively seeking a job constitute the labor force. A person is said to
be unemployed if he/she is in the working age, available for work, actively seeking work, but
doesn’t have one during the census. The unemployment rate measures the ratio of the number of
unemployed to the total number of the labor force (x 100%).
UNEMPLOYMENT RATE = Number of Unemployed X 100%
Number of labor force
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.This type of
unemployment is very common even if the economy is at full employment.
2. Structural Unemployment:this is because of the mismatch between the workers skills
& experience and the skills required by the employers who are hiring the workers. It also
occurs because of the mismatch between the location of job vacancies of the expanding
industries and location of job vacation of the unemployed workers. It 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:occurs when there are fewer vacancies than the unemployed. It
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. Frictional and structural unemployment result from natural and perhaps,
unavoidable occurrences in a dynamic economy. 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/avoidable.
Full employment does not mean zero unemployment. It refers to the situation that occurs when
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 will always be some
unemployed workers looking for jobs. The natural rate of unemployment is the percentage of the
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labor force that can normally be expected to be unemployed for the reasons other than cyclical
fluctuations in real GDP. In other words, the natural rate of unemployment is the sum of the
frictional and structural unemployment expected over the year.
An economy in which the actual unemployment rate is less than the natural rate of
unemployment is termed as an overheated economy. In such a case, the economy can produce
more than the potential real GDP, implying that the economy’s capacity output exceeds the
potential real GDP. However, most economists believe that this couldn’t happen for long periods
without consequences that impair its future performance and ultimately cause actual real GDP to
decline to its potential level.
Cyclical Unemployment tends to increase during contractions (recessions). This negative
relationship between changes in real GDP and changes in the unemployment rate is known as
Okun’s law.
The problem of (cyclical) unemployment is of great concern to economists because it has costs.
The main costs of cyclical unemployment are:
1. Out put is lost (GDP falls) because the economy is not at full employment.
2. Distortional impact –unemployment usually hits poorer people harder than the rich and
this increases the concern about the problem.
3. The unemployed may have more leisure when not working. But, this benefit is more
than offset by the costs to the society since:
i. The value placed on that leisure is small as much of it is unwanted leisure ,and
ii. The government loses income tax revenue and thus,job lose hurts the society than
the individual.

3. Inflation
Inflation is the rate of increase in the general price level for an aggregate goods and services
produced in a nation. When inflation exists the purchasing power of a nation‘s currency declines
over time. Deflation is the opposite of inflation. 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.

Rate of inflation= (CPIt– CPIt-1) x100%

CPIt-1
If the rate of inflation is positive, that will be inflation and if it is negative, it will be deflation.
Measured in this way, inflation is an average of the increases in the prices of all goods and
services in the CPI market basket. The greater the weight attached to an item in the CPI, the
greater the impact of a change in its price on the CPI.
Here, we can identify three concepts:
Pure Inflation: refers to a condition that occurs when the prices of all goods rise by the same
percentage over the year. If an economy experienced pure inflation, there would be no changes
in the relative prices of goods. Thus, pure inflation does not provide consumers with any
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incentive to substitute one goods with the other in their budget, nor does it change the
profitability for sellers of one good rather than another.
Hyperinflation: 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
1. Inflation can result in a redistribution of income and wealth from creditors to debtors. As
a result, inflation can pay back loans in currency units that have 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 savings decreases as a result of inflation.
2. Hyperinflation seriously impairs the functioning of the economy by causing credit
markets to collapse and by wiping out the purchasing power of accumulated savings.
3. Actions taken in anticipation of inflation can adversely affect the performance of the
economy. When buyers and sellers try to anticipate, they base their economic decisions,
in part, on the gains and loses they expect to incur. This can affect the supply of and
demand for particular goods and services thereby distorting market prices.
4. Anticipated inflation can distort consumer choices by causing buyers to purchase goods
now that they might otherwise prefer to purchase in the future.
Inflation could be demand-pull inflation (where high aggregate demand is responsible for it) or
cost-push inflation (where adverse supply shocks are typically events that push up the costs of
production).
Expansionary aggregate demand policies tend to produce inflation, unless they occur when the
economy is at high levels of unemployment.