CHAPTER TWO: NATIONAL INCOME ACCOUNTING

This chapter focuses on the three statistics that economists and policymakers use most often.
Gross domestic product, or GDP, tells us the nation‘s total income and the total expenditure on
its output of goods and services. The consumer price index, or CPI, measures the level of prices.
The unemployment rate tells us the fraction of workers who are unemployed. In the following
pages, we see how these statistics are computed and what they tell us about the economy.

2.1 The concept of GDP and GNP

Gross domestic product is often considered the best measure of how well the economy is
performing. The goal of GDP is to summarize in a single number the dollar value of economic
activity in a given period of time.

There are two ways to view this statistic. One way to view GDP is as the total income of
everyone in the economy. Another way to view GDP is as the total expenditure on the
economy‘s output of goods and services. From either viewpoint, it is clear why GDP is a gauge
of economic performance. GDP measures something people care about their incomes. Similarly,
an economy with a large output of goods and services can better satisfy the demands of
households, firms, and the government.

How can GDP measure both the economy‘s income and the expenditure on its output? The
reason is that these two quantities are really the same: for the economy as a whole, income must
equal expenditure. That fact, in turn, follows from an even more fundamental one: because every
transaction has both a buyer and a seller, every dollar of expenditure by a buyer must become a
dollar of income to a seller. When Joe paints Jane‘s house for $1,000, that $1,000 is income to
Joe and expenditure by Jane. The transaction contributes $1,000 to GDP, regardless of whether
we are adding up all income or adding up all expenditure.

Rules for Computing GDP

In an economy that produces only bread, we can compute GDP by adding up the total
expenditure on bread. Real economies, however, include the production and sale of a vast
number of goods and services. To compute GDP for such a complex economy, it will be helpful
to have a more precise definition:

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Gross domestic product (GDP) is the market value of all final goods and services produced
within an economy in a given period of time. To see how this definition is applied, let‘s discuss
some of the rules that economists follow in constructing this statistic.

1. To compute the total value of different goods and services, the national income accounts
use market prices because these prices reflect how much people are willing to pay for a
good or service. Thus, if apples cost $0.50 each and oranges cost $1.00 each, GDP would
be GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of
Oranges)

= ($0.50 × 4) + ($1.00 × 3) = $5.00.

GDP equals $5.00 the value of all the apples, $2.00, plus the value of all the oranges,
$3.00.

2. Used goods are not included in the calculation of GDP.

3. The Treatment of Inventories depends on if the goods are stored or spoiled
4. Intermediate goods are not counted in GDP- only the value of final goods
Value added of a firm equals the value of the firm‘s output less the value of the
intermediate goods the firm purchase.
Example:
 A farmer grows a bushel of wheat and sell it to a miller for $ 1.00
 The miller turns the wheat in to flour and sell it to a baker for $ 3.00
 The baker uses the flour to a loaf of bread and sells it to an engineer for $ 6.00
 The engineer eat the bread
The value of the final goods already includes the value of the intermediate goods,
so including intermediate goods in GDP would be double-counting.
Thus, Expenditure=income=sum of value added
5. Some goods are not sold in the marketplace and therefore don‘t have market prices. We
must use their imputed value as an estimated of their value. For example, home
ownership and government services.
 A person‘s rent will be included in GDP: your expenditure and landlord‘s income
 How about people who own houses? They pay themselves their rent.

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  How about services of police officers, firefighters and senators? All public goods
and services.
These all are included in GDP.
6. Purely financial transactions are excluded from GDP. These includes:
 public transfer payment;
 private transfer payment; and
 security transfer payment

2.2 Other Measures of Income

The national income accounts include other measures of income that differ slightly in definition
from GDP. It is important to be aware of the various measures, because economists and the press
often refer to them.

To see how the alternative measures of income relate to one another, we start with GDP and add
or subtract various quantities. To obtain gross national product (GNP), we add receipts of factor
income (wages, profit, and rent) from the rest of the world and subtract payments of factor
income to the rest of the world:

GNP = GDP + Factor Payments From Abroad − Factor Payments to Abroad.

NFI= (Factor Income received from Abroad)-(factor income paid abroad).

GNP may be greater, equal, or less than GDP.

If NFI>0, then GNP>GDP

If NFI=0, then GNP=GDP

If NFI<0, then GNP<GDP

Whereas GDP measures the total income produced domestically, GNP measures the total income
earned by nationals (residents of a nation). For instance, if a Japanese resident owns an
apartment building in New York, the rental income he earns is part of U.S. GDP because it is
earned in the United States. But because this rental income is a factor payment to abroad, it is not
part of U.S. GNP. To obtain net national product (NNP), we subtract the depreciation of capital

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the amount of the economy‘s stock of plants, equipment, and residential structures that wears out
during the year:

NNP = GNP − Depreciation.

In the national income accounts, depreciation is called the consumption of fixed capital. Because
the depreciation of capital is a cost of producing the output of the economy, subtracting
depreciation shows the net result of economic activity. The next adjustment in the national
income accounts is for indirect business taxes, such as sales taxes. Once we subtract indirect
business taxes from NNP, we obtain a measure called national income:

National Income = NNP − Indirect Business Taxes.

National income measures how much everyone in the economy has earned. The national income
accounts divide national income into five components, depending on the way the income is
earned. The five categories, and the percentage of national income paid in each category, are

➤ Compensation of employees. The wages and fringe benefits earned by workers.

➤ Proprietors‘ income. The income of non-corporate businesses, such as small farms, mom-
and-pop stores, and law partnerships.

➤ Rental income. The income that landlords receive, including the imputed rent that
homeowners ―pay‘‘ to themselves, less expenses, such as depreciation.

➤ Corporate profits. The income of corporations after payments to their workers and creditors.

➤ Net interest. The interest domestic businesses pay minus the interest they receive, plus
interest earned from foreigners.

Personal Income = National Income

− Corporate Profits
− Social Insurance Contributions
− Net Interest
+ Dividends
+ Government Transfers to Individuals

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 + Personal Interest Income.
Next, if we subtract personal tax payments and certain nontax payments to the government
(such as parking tickets), we obtain disposable personal income:
Disposable Personal Income = Personal Income − Personal Tax and Nontax Payments. We
are interested in disposable personal income because it is the amount households and non
corporate businesses have available to spend after satisfying their tax obligations to the
government.

2.3 Approaches of measuring national income (GDP/GNP)

There are three ways of measure GNP/GDP: Product or final goods approach, Expenditure
approach and Income or value added approach. Each approach gives a different perspective on
the economy. However, the fundamental principle underlying national income accounting is that,
all the three approaches give identical measurements of the amount of current economic activity.
Let us discuss the approaches one by one.

1. The Product Approach: measures economic activity by adding the market values of goods
and services produced in all sectors of the economy‘. This approach computes economic
activity by summing the values realizes by all sectors.
2. Expenditure Approach: this approach is yet another alternative way of calculating the
GDP. It looks at the demand side of the products. In this method we add the final expenditure
that each buyer in the economy makes.

Economists and policymakers care not only about the economy‘s total output of goods and
services but also about the allocation of this output among alternative uses. The national income
accounts divide GDP into four broad categories of spending:

➤ Consumption (C)

➤ Investment (I)

➤ Government purchases (G)

➤ Net exports (NX).

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Thus, letting Y stand for GDP

Y = C + I + G + NX.

GDP is the sum of consumption, investment, government purchases, and net exports. Each dollar
of GDP falls into one of these categories. This equation is an identity an equation that must hold
because of the way the variables are defined. It is called the national income accounts identity.

Consumption consists of the goods and services bought by households. It is divided into three
subcategories: nondurable goods, durable goods, and services. Nondurable goods are goods that
last only a short time, such as food and clothing. Durable goods are goods that last a long time,
such as cars and TVs. Services include the work done for consumers by individuals and firms,
such as haircuts and doctor visits.

Investment consists of goods bought for future use. Investment is also divided into three
subcategories: business fixed investment, residential fixed investment, and inventory investment.
Business fixed investment is the purchase of new plant and equipment by firms. Residential
investment is the purchase of new housing by households and landlords. Inventory investment is
the increase in firms‘ inventories of goods (if inventories are falling, inventory investment is
negative).

Government purchases are the goods and services bought by federal, state, and local
governments. This category includes such items as military equipment, highways, and the
services that government workers provide. It does not include transfer payments to individuals,
such as Social Security and welfare. Because transfer payments reallocate existing income and
are not made in exchange for goods and services, they are not part of GDP.

The last category, net exports, takes into account trade with other countries. Net exports are the
value of goods and services exported to other countries minus the value of goods and services
that foreigners provide us. Net exports represent the net expenditure from abroad on our goods
and services, which provides income for domestic producers.

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3. The Income Approach: Sums of all income values realized in the economy. Six income
structures, namely compensation of employees, rent, interest, depreciation, indirect business
tax and profit constitute the GNP/GDP calculated using income approach

Whichever approach that we may follow there are three major criticisms of the GDP measure:

It omits non market goods and services. For example Work of stay at home mothers are not
included in the GDP measure.

It does not account for ―bads‖ such as underground economy. Crime and pollution. For example,
crime is a detriment to society, but there is no subtraction from GDP to account for it.

2.4 Real GDP Versus Nominal 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,

GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges).

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 nominal GDP.

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,
real GDP shows what would have happened to expenditure on output if quantities had changed
but prices had not.

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To see how real GDP is computed, imagine we wanted to compare output in 2002 and output in
2003 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 2002. Goods and services are then added up using
these base-year prices to value the different goods in both years. Real GDP for 2002 would be

Real GDP = (2002 Price of Apples × 2002 Quantity of Apples) + (2002 Price of Oranges × 2002
Quantity of Oranges).

Similarly, real GDP in 2003 would be Real GDP = (2002 Price of Apples × 2003 Quantity of
Apples) + (2002 Price of Oranges × 2003 Quantity of Oranges).

And real GDP in 2004 would be Real GDP = (2002 Price of Apples × 2004 Quantity of Apples)
+ (2002 Price of Oranges × 2004 Quantity of Oranges).

Notice that 2002 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.

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=

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, bread. If P is the price of
bread and Q is the quantity sold, then nominal GDP is the total number of dollars spent on bread
in that year, 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 GDP deflator is the price of bread in that year
relative to the price of bread in the base year, P/P base.

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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. We can also write this equation as

Real GDP=

In this form, you can see how the deflator earns its name: it is used to deflate (that is, take
inflation out of ) nominal GDP to yield real GDP.

Measuring the Cost of Living: The Consumer Price Index

A dollar today doesn‘t buy as much as it did 20 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. In later chapters we examine in detail the causes and
effects of inflation. Here we discuss how economists measure changes in the cost of living.

The Price of a Basket of Goods

( ) ( )
CPI= ( ) ( )

In this CPI, 2002 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 2002. 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.
2.5 The CPI Versus the GDP Deflator
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

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 services bought by consumers. Thus, an increase in the price of goods bought 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 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.
2.6 The business Cycle
The business cycle is a four phase normal fluctuation of a market economy. Whether we are
examining a single firm, a particular industry, or the whole, Market fluctuations are present
at all levels
1. Prosperity or boom or peak: it is a phase of economic activity characterized by rising
demand, rising prices, rising investment, rising employment, rising incomes, rising
purchasing power and hence rising demand and so on. The investors, therefore, voluntarily
undertake risks and go in for investment, this further fuels boom conditions through the
working of the multiplier effect.
2. Recession: during the boom period, the economy may get over- heated and the monetary
authorities, the financial institutions and the business itself may begin to play cautious. There
may be cuts in investment, resulting in cuts in employment, fall in incomes, decline in
purchasing power and demand. Prices may begin to fall.
3. Depression or slump or trough: if the effective corrective measures cannot be
undertaken, the economy may find itself go into depression. It is a stage when the business
confidence is at its lowest. Investment, employment, output, income and prices touch the
bottom.

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 4. Recovery or expansion: as the economy moves out of depression, it enters the phase of
recovery. Sustained recovery will find the level of investment, employment, output, income
and prices moving upwards. This may finally results in boom conditions in the economy.

Trend

Output

Peak
Recovery

depression
Recession nnn

Figure 2.1 The Business Cycle

Deviations of output from trend are referred to as the output gap. The output gap
measures the gap between actual output and the output the economy could produce at
full employment given the existing resources. Full employment output is also called
potential output.
Output Gap = Potential output – actual output
When looking at the business cycle fluctuation, one question that naturally arises is
whether expansion gives way inevitable to old age, or whether they are instead brought
to an end by policy mistakes. Often a long expansion reduces unemployment too much;
causes inflationary pressures, and therefore triggers policies to fight inflation-and such
policies usually create recessions.
Okun’s Law
What relationship should we expect to find between unemployment1? Because
employed workers help to produce goods and services and unemployed workers do not,
increases in the unemployment rate should be associated with decreases in real GDP.

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This relationship between real growth and changes in the unemployment rate is known
as Okun’s law, named after its discoverer, Arthur Okun. Okun’s law says that the
unemployment rate declines when growth is above the trend rate.
u     y a  yt 

Where u is a change in unemployment,  the magnitude in which unemployment

declines due to a percentage point growth, ya actual growth rate of output and yt is the

trend output growth rate. Figure 2.2 below shows the Okun’s law relationship between
unemployment and growth in output.

Percentage
change in real
GDP

Change in unemployment rate

Figure 2.2 Growth and Unemployment Dynamics

2.7 Unemployment and Inflation

2.7.1 Unemployment

Dear Students! Unemployment is the macroeconomic problem that affects people most directly
and severely. For most people, the loss of a job means a reduced living standard and
psychological distress. It is no surprise that unemployment is a frequent topic of political debate
and that politicians often claim that their proposed policies would help create jobs.
Unemployment rate is the percentage of total labor force that is currently unemployed (total
unemployment divided by total employment force times 100).
Let L denote the labor force, E the number of employed workers, and U the number of
unemployed workers. Because every worker is either employed or unemployed, the labor force is
the sum of the employed and the unemployed:
L = E + U, In this notation, the rate of unemployment is U/L.

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 1. Frictional unemployment

One reason for unemployment is that it takes time to match workers and jobs. The
unemployment caused by the time it takes workers to search for a job is called frictional
unemployment. At any point of time, some workers will be in ‗between jobs‘. That is some
workers will be in the process of voluntary switching jobs. Others will have job connections but
will be temporarily laid off because of seasonality or model change occurs. In fact, workers have
different preferences and abilities, and jobs have different attributes. Furthermore, the flow of
information about job candidates and job vacancies is imperfect, and the geographic mobility of
workers is not instantaneous. For all these reasons, searching for an appropriate job takes time
and effort, and this tends to reduce the rate of job finding. Indeed, because different jobs require
different skills and pay different wages, unemployed workers may not accept the first job offer
they receive.

2. Structural unemployment

A second reason for unemployment is wage rigidity—the failure of wages to adjust until labor
supply equals labor demand. Sometimes the real wage is stuck above the market-clearing level.
When the real wage is above the level that equilibrates supply and demand, the quantity of labor
supplied exceeds the quantity demanded. Firms must in some way ration the scarce jobs among
workers. Real-wage rigidity reduces the rate of job finding and raises the level of unemployment.
The unemployment resulting from wage rigidity and job rationing is called structural
unemployment. Workers are unemployed not because they are actively searching for the jobs
that best suit their individual skills but because, at the going wage, the supply of labor exceeds
the demand. These workers are simply waiting for jobs to become available.

3. Cyclical unemployment

A factor of overall unemployment that relates to the cyclical trends in growth and production
that occur within the business cycle is referred to as cyclical unemployment. When business
cycles are at their peak, cyclical unemployment will be low because total economic output is
being maximized. When economic output falls, as measured by the gross domestic product
(GDP), the business cycle is low and cyclical unemployment will rise. Often cyclical

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unemployment can cause a rise in the natural rate of unemployment. If young people are out of
work for a long time in a recession, it can be difficult to get back into employment because of
lack of job experience and decline in motivation.
2.7.2 Inflation
Inflation is a rising general level of prices. Inflation has got different kinds of social costs. Some
of the social costs of inflation are:
 Inflation leads to lower real money balances held by the public. If people are to hold
lower money balances on average, they must make more frequent trips to the bank to
withdraw money. This inconvenience is referred to as Shoe-leather cost of inflation
because walking to the bank more often causes one‘s shoes to wear out more quickly.
 Inflation induces firms to change their posted prices more often which is also costly.
 The higher the inflation is the greater the variability in relative prices which leads to
microeconomic inefficiencies in the allocation of resources.
 Inflation arbitrarily redistributes wealth among individuals.
 It also hurts individuals on fixed pensions.

Various indexes have been devised to measure different aspects of inflation. Two commonly
used indexes are the Consumer Price Index (CPI) and the Producer Price Index (PPI). The CPI
measures inflation as experienced by consumers in their day-to-day living expenses. The method
used to construct the CPI compares the current and base year cost of a basket of goods and
services of fixed composition. For the CPI the base is a fixed "market basket" or bundle of goods
and services representative of the purchases of urban consumers. The index is the ratio of today's
cost of the fixed bundle to the base year cost of the same bundle. This kind of index implicitly
assumes that the consumer's consumption pattern does not change in response to any price
changes.

The alternative index to the CPI is the Producer Price Index (PPI). PPI is an index that measures
the average change over time in selling prices by domestic producers of goods and services. PPI
measures price change from the perspective of the seller.

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There are different types of inflation:
Monetary Inflation: According to economist Milton Friedman, "inflation is everywhere and
always a monetary phenomenon." In other words, a sharp increase in consumer prices always
results from the Treasury putting money into circulation at a faster rate than the economy is
actually creating value. "Value," in this sense, means the actual existing demand for the products
within the economy. Therefore, if there is more money, but not more value, the purchasing
power of the currency will decrease, which manifests itself as a price increase.

Demand-pull inflation: changes in the price level have been attributed to an excess of total
demand. The business sector cannot respond to this excess demand by expanding real output for
the obvious reason that all available resources are already fully employed. Therefore, this excess
demand will bid up the price of the fixed real output, causing demand pull inflation.

Cost push inflation: inflation may arise on the supply or cost side of the market. Unions have
considerable control over wage rates. They obtain a wage increase. Large corporate employers
faced now with increased costs but also in the possession of considerable market power, push
their increased wage cost on to consumers by raising the prices of their production.

Built-in Inflation: This is the more abstract concept that inflation also occurs due to past
experiences with inflation. Manufacturers assume that inflation will always occur and, in
anticipation of this, raise their nominal prices before the actual value increases, thus creating
more inflation on top of the other types of inflation.
A price index measures the general level of prices in reference to a base year period. Annual
rates of inflation are measured by the percentage change.
Rate of inflation (year t) = CPI year t – CPI year t-1 x 100
CPI year t-1
Example: In 1992 the market basket price of a commodity was 144.5 birr, in 1993 the same
market basket costs 148.2. Calculate the rate of inflation.
RI (1993) = CPI 1993 – CPI 1992 x 100
CPI 1992
148.2 – 144.5 x 100 = 2.6%
144.5

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