Chapter Two: National Income Accounting Framework

Chapter objective
The central objective of the lesson is to help students acquire a general understanding
about the primary bases and variables used to measure the performance and changes in
macroeconomic fields. It also provides a fair analysis over the commonly applied
components of aggregate demand and that of national income identities. More
specifically, students are expected to
• Define terminologies of national income accounting system
• Explore the techniques how to accurately measure macroeconomic activities.
• Familiarize with the basic equations of national income accounting.

Key Concepts

Gross domestic product Real Vs Nominal GDP

Gross national product Net Domestic Product
Net national product personal disposable income
Expenditure Approach Net National Product
Income Approach Value Added Approach

2. 1. Basic Concepts National Income Accounting System

The lesson aims at defining the fundamental concept of national income accounting
system.

Dear Learners!!
As discussed in chapter one, macroeconomics deals with the economy activities as
whole. This indicated that it relies heavily on data, much of it collected by the
government. But it could be collected even by private sector and non-governmental
organizations. Those data compiled in the national income accounts. Thus, national
income accounting is developed to measure the overall economic performance of an
economy in a given time period over an accounting period economic agents engage in a
variety of economic activities of production and consumption by providing various data.

Therefore, a system of accounts is needed to provide us with a record of how our

economy works. National income accounting provides aggregate measures of the
market values of the final goods and services produced in the economy during a one-
year period. In general, national income accounting is a record of the level of economic
activities of an economy. It is a measure of aggregate output, income, and expenditure in
an economy.

Student Activity

Differentiate between national income and national income accounts?

What is national income accounting system?

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2. 2. Importance of National Income Accounting System
The rationale of this chapter is to explore the various advantages of national income
accounting system.

Dear distance students!!

Could you mention two advantages of national income accounts?
National income accounting framework is a system of recoding the different macro data
of the economy, which are collected by the government, private sectors, professions and
nongovernmental organizations, in single compiler manner. Thus, national income
accounting is important for the following reasons.
1. It enables a country to measure the total level of output in an economy in a
given period of time, and to explain the causes-effects for such level of
performance of the economy.
2. It enables a country to observe the long run trend of its economy. I.e. it enables
us to know whether the economy is growing or stagnating.
3. It also compares the national income accounts over a period of time and with
different countries.
4. It provides information which basis for the formulation and application of
policies that can help improve the economic performance.

2. 3. Output measurement of National Income Accounting System

The purpose of this lesson is to introduce students with the different techniques that are
used to measure macro data in general and national output (income) in particular.

Dear Distance Students!!

In the national income accounts, we obtain different types of macroeconomics data.
Price, income, employment, output, interest rate, exchange rate, and so forth are among
the many macro data. We can use different techniques to measures the different macro
data. Even to measure a single macro data, we can use various approaches.

For instance, to measure the total market value of final goods and services produced in
an economy in a given year, macroeconomists use many conceivable measures. The
basic social accounting measure of the total output of goods and services are
1. Gross National Product (GNP)
2. Gross Domestic Product (GDP)
3. Other account units

2. 3. 1. Gross National Product: Concepts and Approaches

Dear learners!!
Upon completion of this lesson, you will grasp

The definition of gross national product

Basic concepts and approaches of gross national product
Gross National product is the most important and widely used measurement of national
income (output). GNP refers to the total market value of all final goods and services
produced by domestically owned resources in an economy during a year. There are

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several points worth noting in this definition. Put differently, while computing GNP,
please pay attention for the following concepts.
1. Market value concept. A country produces a large number of goods and services.
So, it is impossible to add up all these goods and services because they have different
units of measurement. For example, it is not possible to add 100 cars and 1000 quintals
of teff. There fore, to add them up we need a common unit of measurement. This
common unit of measurement is money or market value (price) of these goods or
services. Thus GNP must monetary measurement.

2. The value of final goods and services. To measure total output accurately, all
goods and services produced in any given year must be counted once but not more than
once. But most products go through a series of production stages before reaching a
market. Thus GNP only includes the final goods and services but excludes the
intermediate goods to avoid double counting because the value of final goods already
includes all the intermediate transactions involved in their production.

Those goods and services produced for final use, not for resale or further processing are
final commodities♠. Goods and services that are completely used up in the process of
production are called intermediate good♥. Therefore, GNP does not include the value of
intermediate goods because their value will be added to the final good. Rewords, the
double counting can be avoided by counting only the value added by each firm in its
production process. Value added is the difference between the values of goods as they
leave that stage of production and the cost of the goods as the entered that stage or it is
the market value of a firm’s output less the value of the inputs which it has purchased
from others.

To make it clear, suppose there are five stages of production in getting a wool suit
manufactured into the hands of a consumer who is the ultimate or final user. The below
indicated table shows the value added in a five stage production process (hypothetical
data). Thus, GNP includes only the 250 but not the 710.

Table 2. 1. Production line of wool cloth production

Firm Stage of production Value of sales Value added
A Sheep Ranch $60 $ 60
B Wool Processor 100 40
C Suit Manufacturer 125 25
D Clothing Whole Sales 175 50
E Retail Clothier 250 75
Total sales value $710
Value added (total income) $250

3. Current year production level. GNP refers to the value of final goods and services
that are produced currently. GNP measures current production only. Goods produced

♠
Final goods- good that does not require further processing so purchasing for final use (clothing purchased by a consumer and machine purchased by a
manufacturer).
♥
Intermediate goods and services are those that require further processing during the year before they are ready for final use; are being purchased for
modification before final use; and will be resold during the year for profit. Example: A loaf of bread is final commodity if it is bought by a household for
final consumption. Still, it remains an intermediate good if purchased by a cafeteria for use to prepare sandwich.

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during the previous period (last year) but sold in the current period are not part of this
year’s GNP. For example, a car produced last year but resold this year will not be
counted as part of this year’s GNP. Thus, GNP excludes unsold and second hand sales
because either reflect no current production or involve double counting.

4. Out put produced by foreign owned factors of production. The product produced
by Ethiopian citizens, even when they are working abroad for a foreign company, is
counted in Ethiopia GNP. Profits earned abroad by Ethiopian companies, which are
payments to the capital those companies own, are also counted. On the other hand, the
income of foreigners working in Ethiopia is not counted even if those foreigners work
for Ethiopia Company. Likewise, profits of foreign companies earned in Ethiopia even if
the plants of the foreign companies are located in Ethiopia are not counted in Ethiopia
GNP.

To speak differently, GNP measures the total output produced by domestically owned
factors of production wherever they are employed. For example, the total output
attributed to the Ethiopian tycoon Ali Alamudin because of his investment in Sweden is
not Part of Swedish GNP but Ethiopian. This is because the resource (investment) is
Ethiopian. On the contrary, GNP does not include output attributable to foreign owned
resources. For example, the value the roads being built in our country by Chinese
resources is part of china’s GNP, not Ethiopia’s GNP.

5. Non-production transaction. GNP excludes the non-production transaction such as

purely financial transaction since they don’t entail production.

Private transfer payments – these payments are simply the transfer of funds
from one private individual to another. For instance, this includes occasional gift
from a wealthy relative, university student’s monthly subsidy etc.

Public transfer payments – this is the process in which the government makes
the payment to particular households or business firms. The recipients make no
contribution to current production in return for them. This includes social
security payments, welfare payments, and veterans’ payments

Security transactions-buying and selling of stocks and bonds are also excluded
from GNP. For instance, if I sell the stock for more than I originally paid, the
profits from the bond market have nothing to do with current production and
thus they are not counted in GNP. If, on the other hand, I pay a fee to broker for
selling a stock of mine to some one else, this fee is counted in GNP, because the
broker is performing a services for me just like my barber or my lawyer does in
this case selling my stock. This service is part of current production.

After defining GNP, the central question is that how can the market value of all final
goods and services be measured? The measurement of total output at market value is
possible in three ways (approaches): The value added approach; Expenditure approach;
and Income approach. Expenditure approach considers the sum of all expenditures
involved in taking the total output of the market. The expenditure approach adds up all
types of spending on final goods and services. The Income approach considers the sum
of the income received or created from the production of final goods and services. The
value added approach considers the net value of outputs produced in the economy.

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There is one important law known as equity law, states that measuring GNP by
making use of the three approaches leads to the same result because each is trying to do
the same thing-to measure the total value of goods and services produced during the
current period. A dollar’s worth of final product generates a dollar of income. That is
one-dollar expenditure generates one-dollar income. Therefore, those who contributed
to its production receive what is spent on products as income. In general,

The amount spent on final The money income derived or received

goods and services during the Equals from the production of the current
current period period’s final goods and services

Expenditure on goods and services =Income from goods and services

I. VALUE ADDED APPROACH

Dear students! Do you know the literal meaning of value added?
This is the least common used method. It computes the value of GNP by adding the
values of each sector in the economy. Computing the value added of each sector is prime
task (differentiate between the final market value of each sector’s output and the amount
incur in each sector to produced such output) and then adding the value added of each
sector is the subsequent task of this approach.

Value Added = value of output- value of intermediate inputs.

GNP = Value Added of agricultural output
+ Value added of industrial output
+ Value added of service sector output

II. THE EXPENDITURE APPROACH

Dear learners!!

This is the second approach which uses to measure the value of final goods and services
produced using the country’s resources in a given period of time. Expenditure the
amount spent on all final goods and services during a given period. In this approach,
GNP is, therefore, measured by adding all expenditures on final goods and services
produced during the current period. It includes four items.

1. Personal consumption Expenditure (C) – this is a type of expenditures made by

households (individuals) on final goods and services for consumption purposes. Personal
consumption expenditure includes spending on consumer durables (goods that can be
used for a long period of time like radio, TV, car, etc.), consumer none-durables (those
goods that are consumed in short period of time such as food, fuel, cigarettes, etc.), and

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services (intangible benefits that people receive from various activities) so that made
expenditures for them such as on doctor, lawyers, barber, education etc.
2. Gross private domestic Investment (I) - This refers to sum total of all expenditures
made by the private sector (business firms) for the purpose of investment. Gross private
Domestic Investment includes:

Fixed investment - expenditure made on machinery, equipment, tools, etc;

Construction- all expenditures made on residential (Houses or buildings
(apartment) for living or for rent to yield money) and non-residential (buildings
constructed for production and distribution purposes, such as factory complexes
and warehouses, etc)

Change in inventories - unsold outputs that are currently produced i.e. outputs
that the firm produces now for sale later. If parts of currently produced outputs
are not sold this year, then inventories increase. These are counted as firms’
investment. Increases in inventories are additions to GNP while decreases in
inventories are deductions from GNP.

Dear distance student

The point is why inventory needed?
The question what service does inventory provides is central. Firms keep and maintain
stocks of inventory for a number of reasons, especially to meet unforeseen demand i.e.
firms provide direct services to customers with inventory, and to smooth the production
process because firms are never sure how much they will sell from period to period.
Sales go up and down. To maintain the good will of their customers, therefore, firms
need to be able to respond to unforeseen increases in sales. The way to do that is with
inventory.

The change in business inventories is a volatile component of GNP since fluctuations in

inventories can be a large component of over all fluctuations in GNP. The change in
business inventories in the national income accounts is the sum of all inventory changes
of all firms in the economy. In all, inventory change is the difference between what
produce and what sales.

Were we to exclude an increase in inventories, GNP would understate the current

year’s total production because if firms have more goods on their selves and in their
warehouses at the end of the year than they had at the start, the economy has produced
more than it has consumed during this particular year and so must be added to GNP as
a measure of current production. Thus, an increase in inventories must be added to
GNP.

On contrary, a decrease in inventories must be subtracted from GNP because the

economy sells a total output, which exceeds current production; the difference being
reflected in an inventory reduction. A decline in inventories in any given year means
that the economy has purchased more than it has produced during the year and the
society has consumed all of this year’s output plus some of the inventories inherited
from previous year’s production.
Dear students!!

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Let’s return back our mind to the domestic and private terms. Domestic indicates the
firms doing the investing are local citizens as opposed to foreign firms. The private also
shows the spending is by private business enterprises as oppose to governmental
agencies. Thus gross private domestic investment includes the production of all
investment goods- those which are to replace the machinery, equipment and buildings
used up in the current year’s production plus any net additions to the economy’s stock
of capital.

In short, gross investment includes both replacement and added investment, and it
ignores depreciation and replacement costs. This implies that net investment refers only
to the added investment, which has occurred in the current year. A depreciation or
capital consumption allowance is the amount of capital consumed or used up during a
period. Net investment is useful concept compare to gross investment because it tells us
how much the capital stock has changed during the period and shows the economic
aspect.

Gross Investment= Net Investment + Depreciation

End period’s Capital Stock = Beginning period’s Capital Stock + Net Investment

a. Expanding economy - when gross investment exceeds depreciation. In this case,

net investment is positive. Thus, the economy is expanding in the sense that its
productive capacity, measured by its stock of capital goods, is growing.
b. Static/stationary economy - reflecting that gross investment and depreciation
are equal so that net investment is zero. The economy is standing pat; producing
just enough capital to replace what is consumed in producing the year’s output.
c. Declining economy - the unhappy case of a declining economy arises whenever
gross investment is less than depreciation i.e. when the economy uses up more
capital in a year than it manages to produce. Net investment is negative. The
economy will be disinvesting. Depressions foster such circumstances. During
bad times, when production and employment are at low ebb, the nation has a
greater productive capacity than it is currently utilizing.

3. Government expenditure on goods and services (G) - these include any expenditure
made by federal, state, and local governments on currently produce goods and services.
Note that all the expenditures made by the government sector will not be counted. Only
those expenditures made to purchase currently produced goods and services are
included, for instance, expenditures on national defense, police and fire protection,
public school operation, roads, hospitals, etc.

Government transfer payments such as social security benefits, veterans’ disability

stipends etc are not included. Because those transfers are not purchases of any thing
currently produced and are not made in exchange for any goods and services. Besides,
interest payments on the government debt are also counted as transfers.

4. Net Export (X-M) - This refers to the excess of Exports over and above imports. Net
export equals exports minus imports. Exports refer to market value of goods and

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services produced in this country and sold abroad; and imports are goods and services
produced abroad and purchases here at home. In other words, net export is the amount
by which foreign spending on Ethiopian goods and services exceeds Ethiopian spending
on foreign goods and services.

This is because we are trying to add up all spending in Ethiopian markets which
accounts for or induces the production of goods and services in the Ethiopian economy.
Hence, we want to add in what foreigners spend on Ethiopian goods and services while
determining GNP by the expenditure approach. On the other hand, we must recognize
that a portion of consumption, investment, and government purchases is for goods
which have been imported i.e. produced abroad and therefore doesn’t reflect production
activity in Ethiopia. The value of imports is subtracted to avoid an overstatement of
total production in Ethiopia.
In general, GNP in the expenditure approach can be calculated as:
GNP=C+IG+G+(X-M)

Table 2. 2. GNP computation using the Expenditure Approach

Personal Consumption Expenditure $1,672.8

Gross Private Domestic Investment 395.3
CCA 287.3
Net investment 108.0
Government Purchases of Goods and Services 534.7
Net export (Export - Import) 23.3
GNP $ 2,626.1

III. THE INCOME APPROACH TO GNP

In the income approach, GNP is determined by adding up the income earned by the
domestically owned factors of production and two non-income changes against GNP.
Here, we look at GNP in terms of who receives it as income rather than in terms of who
purchases it. This includes:

1. Compensation of Employees (W) - this includes primarily wages and salaries. It also
includes an array of wage, fringe benefits and salary supplements, in particular
payments by employers into social insurance, health care, private pension etc.
2. Rental income(R) - consists of income payments received by households, which
supply property resources such as land.
3. Interest income (I) - is money income payments received by money lenders
(suppliers) from private business. Rewords, it is the interest on loans paid by business to
the householders that made the loans. But interest paid by households and by the
government is not counted in GNP because it is not assumed to flow from the
production of goods and services. Thus it includes the net interest.

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4. Profit (∏) - is a residual representing what is left over for producers after paying
wages, interest and rent. Profit is broken into two accounts.

Proprietors’ income - which refers to the net income of sole proprietorship,
partnership and cooperatives. Hence, it is some times called income of
incorporated business.

Corporate profit - is the profit of a corporate business which is divided into
(1) corporate income tax that goes to the government as tax, (2) dividends
which goes to stockholders, owners of the business, and (3) undistributed
corporate profit/ retained earning- a residual representing what is left over
after corporate income tax and dividends are reduced from corporate profit.
5. Capital consumption allowance (depreciation, CCA) – this refers to the usefulness of
most capital goods decreases over the course of the asset’s lifetime because of wear and
tear. In national income accounting, the adjustment made for the wearing out of capital
goods during the production of output in the current period is the capital consumption
allowance (CCA).

GNP includes gross investment but not net investment in the expenditure approach.
But, in the calculation of corporate profits, depreciation is subtracted from revenue
though it doesn’t involve in actual expenditure. This implies that GNP is lower by the
amount of depreciation in income approach than the expenditure one. Thus, to balance
GNP as calculated on the product side, we have to add the depreciation back to
corporate profits on the income side. This justifies that all of GNP can’t be consumed as
income by society with out impairing the economy’s stock of production facilities.

6. Indirect business taxes (IBT) - this includes sales taxes, excise tax, business property
tax, license fees and custom duties. These taxes are treated as cost of production by
business firms and therefore, are added to the price of the product they sale. Since this
value of the notation’s output is not available as wages, rents, interests, or profits we
should add it to our GNP. On the opposite side, subsidies are like negative taxes and so
they must subtracted from the income side. Just as indirect taxes are expenditure with
no corresponding income, so too subsidies are an income item of firms with no
corresponding expenditure. Thus, subsidies are an income item for firms but an
expenditure of the government.

For instance, suppose that the sales tax is 7% and that a firm sells 1000 house appliances
for $10.00 per unit plus tax. The total sales price is thus $10070.00 and this is the value
of output recorded on the expenditure side in calculating GNP. Of this, $70.00 goes to
pay the tax to the government, some goes to pay wages and related benefits of the
workers in the factory, some goes to pay interest and the rest is the income (profits plus
depreciation) of the firm. Thus, total sales revenue before tax=$10000.00; Tax revenue
=$70.00, and total sales revenue after tax=$10070.00.

Table 2. 3. GNP using income Approach

Employees compensation $1,597.0
Rent 110.0
Interest 101.0
Business Income (Profit) 313.3
Proprietors’ Income 130.6
Corporate Profit tax 82.3
Dividends 56.0
Undistributed corporate profit 44.4
Capital Consumption Allowance 20 287.3
Indirect Business Tax 217.5
GNP $ 2626.1
2. 3. 2. Gross Domestic Product

Dear Learners!!
What makes gross domestic product differs from gross national product?
Gross Domestic product (GDP) is the total market value of currently produced final
goods and services that are produced within a country’s border during a year. GDP is
the total output produced within the territory of country regardless of the resource
owner. For example, the value of the roads built by Chinese company in Ethiopia is part
of our GDP. In addition, the value of all goods and services produced in Sweden as a
result of investment by the Ethiopian tycoon, Mr.Ali Alamudin is Swedish GDP not
Ethiopian GDP. The value of all goods and services produced in Ethiopia by all
foreigners is included in Ethiopia’s GDP.

Remember that GDP takes into account all currently produced final goods and services
produced within the country’s boundary, irrespective of whether they are produced by
foreign and domestically owned factors of production. But in GNP, we take into account
those final goods and services currently produced by domestically owned resources
irrespective where those resources are.

In short, GNP includes incomes received by residents from abroad and excludes
incomes which are produced locally but accrue to the non-residents (i.e. the output
created in a foreign country by the means of production owned by the residents is added
to and output produced; in the home country, by foreign owned resources are deducted
from GNP); whereas in case of GDP, it is just the other way round; it includes the
incomes received produced locally but accruing to non-residents.

Suppose that R represents for incomes received by residents from abroad, P is local
incomes paid out to non-residents and NFI is net income from abroad; Then, GNP and
GDP can be compared as follows:

NFI=R-P= Income Inflow – Income Outflows

If NFI=0, GNP = GDP
If NFI>0, GNP > GDP
If NFI<0, GNP< GDP

2. 3. 3. Other Social (National Account) Units

I. Net National Product (NNP) - Gross national product is one measure of a nation’s
output but it is a gross measure; does not take into account the capital consumed in the
production of that output. If we desire the net measure of output, we seek the net
national product (NNP) defined as GNP minus capital consumption allowance (CCA).
That is,
NNP=GNP-CCA

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The NNP is important because it tells us how much total output is available for
distribution while still keeping the stock of capital intact. It gives us some ideas of how
much we can consume as a nation without impairing our productive capacity. Hence,
NNP is better measurement of how the economy is doing than the GNP if we are
interested in examining the economy’s long run growth prospects; we need to know by
how much the capital stock has been growing. From the above example, NNP is given
by,

Gross National Product (GNP) $ 2626.1

Capital Consumption Allowance (CCA) (287.3)
Net National Product (NNP) $ 2338.8

II. National Income (NI) - Neither GNP nor NNP, however, gives us an accurate
measure of how much income is actually earned by the various factors of production
such as land, labor, entrepreneurship and capital. The reason is that product prices are
augmented by various indirect business taxes (IBT), the value of which is not part of the
earnings of the factors of production. National income consists of the sum of wages and
salaries, proprietor’s income, rental income of individual, corporate profit and interest
income. Thus, the measure that most accurately reflects the income earned is called
national income (NI), which is defined as:
NI=NNP-
NI=NNP-IBT +Subsidy=
+Subsidy= GNP-
GNP-CCA-
CCA-IBT+SUBSIDY

Using the above example,

Net National Product $ 2,338.80

Indirect Business Tax (217.50)
National Income $ 2,121.30

III. Personal Income (PI) - National income is not a good measure of the amount of
income that individuals receive. Another concept, personal income (PI), has therefore
been developed. To arrive at personal income, a number of adjustments must be made to
national income. The important items are these:

a. Part of employee compensation is subject to social security taxes that go to the

government to pay for our social insurance programs. These payments, technically
refer to social security contribution, are part of the income earned but they are not
part of personal income. Contributions for social insurance must be subtracted from
national income. These social security programs include old age and survivors’
insurance payment, unemployment compensation, welfare payment, pension,
veterans’ payment, educational allowances, disability payment, etc.
b. Not all corporate profits become part of income. Corporations do pay dividends out
of profits to people whom own shares of corporate stock. (This part is distributed
and does become part of personal income). But the taxes that are paid to the

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 government on profits (corporate profit taxes) are not part of personal income.
Therefore, corporate profit taxes and undistributed corporate profit must be
subtracted from national income.
c. Transfer payments which include government transfer, business transfer and
individual transfer do not have associated with them production of goods and
services. They are, therefore, not included in value added, nor are they part of
earned income. But transfer payments add up to personal income and, therefore, are
added to national income. Combining all these item, personal income is defined as
follows:

Thus, we must subtract from national income, income earned but not received and add
income received but not currently earned since it is the income received by households
before paying personal income taxes but after paying social insurance contributions.

PI=NI -Contribution for social insurance

-Corporate profit taxes
-Undistributed corporate profit
+ Transfer payments
+personal interest income received

Given the previous information or data,

National Income $ 2,121.3

Social Security Contribution (203.7)
Corporate profits taxes (82.3)
Undistributed corporate profit (44.4)
Transfer payments 370.2
Personal Income (PI) $ 2.161.10

IV. Disposable Personal Income (DPI) - Personal income does not tell us how much
income people have available to spend for the goods and services they want. To arrive at
disposable personal income, we need to subtract out personal income taxes. Personal
taxes consist of income taxes, personal property taxes, inheritance taxes, gift taxes,
lottery taxes, etc.
DPI=PI-Personal income taxes
=consumption + saving

Given the previous information or data,

Personal Income $ 2,161.10

Personal Income Taxes 23 (338.50)
Disposable Personal Income (DPI) $ 1,822.60
The following table summarizes the various income concepts and their relationships.

Table 2. 4. Summary of national income accounting

Gross national product (GNP) $2,626.10

Less capital consumption allowance (CCA) - 287.30
Equals net national product (NNP) 2,338.80
Less indirect business taxes -217.50
Equals national income (NI) 2,121.30
Less contribution for social insurance -203.70
Less corporate profits taxes -82.30
Less undistributed corporate profits -44.40
Plus transfer payments +370.20
Equals personal Income (PI) 2,161.10
Less personal taxes -338.50
Equals Disposable Personal Income (DPI) $1,822.60

V. Personal Saving(S) - The amount that households have per period that is left over
after they have spent whatever they are going to spend in that period. Personal saving
rate is a percentage of personal disposable income that is saved. If low demand is high
and households are spending a lot relative to their incomes; if it is high, demand is low
and households are spending cautiously.
S=DPI – personal consumption expenditure
- Interest paid by consumers
- Personal transfer payment

2. 4. Limitations of GNP concepts

Dear Learners!!
By now you are familiarize with the basic concepts of GNP. This lesson therefore deals
with the fundamental limitations of the national income accounting system.

GNP is a reasonably accurate and extremely useful measure of national economic

performance. An increase in GNP is good since it is among the chief goals of
government’s macroeconomic policy. Some serious problems arise when we try to use
GNP as a measure of happiness or well-being. Thus, the following are some of the
limitations.

1. GNP and social welfare - A decrease in crime clearly increases social welfare; society
would be better off but a decrease in crime is not an increase in output and thus it has no
effect on GNP. An increase in leisure time is an increase in social welfare. Some
increases in social welfare are associated with a decrease in GNP. An increase in leisure
during a time of full employment leads to a decrease in GNP since time is spent at
work-requiring output.

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There are also certain production transactions which don’t appear in the market (Non-
market transactions). In this case, GNP as a measure of the market value of output fails
to include these production transactions and understates the economy’s GNP. Standard
examples include the production service of a home maker, the efforts of carpenter who
repairs his/ her own home, the work of the erudite professor who writes a scholarly but
non-remunerative article, child care and house work and so on. However, the salaries of
daycare staff, cleaning people and chauffeurs are counted in GNP.

Along with this, GNP is quantitative rather than qualitative measure. It doesn’t
accurately reflect improvements in the quality of products. Quality improvement clearly
affects well-being of the society. To the extent that product quality has improved over
time, GNP therefore understates improvement in our material well-being. Together
with this, changes in the composition and allocation of total output (distribution) among
specific households may influence economic welfare.

GNP, however, reflects only the size of output and doesn’t tell us any thing about
whether this collection of goods is right for society. In short GNP measures the size of
the total output but doesn’t reflect changes in the composition and distribution of
output which might also affect the economic well-being of society.

2. GNP and per-capita-output - the most meaningful measure of economic well-being

is per-capita-output but GNP misrepresents or conceals changes in the standard of
leaving of individual households in the economy. The per capita income refers to the
share of average national income per household. In other words, it is obtaining by
dividing the total national income to the total population of the economy.

3. GNP and the environment - GNP doesn’t reflect pollution, degradation, congestion,
which affects the well-being of the society. Thus GNP overstates our national economic
wafer.
4. Underground economy- they are relatively large and expanding underground sector
in our economy. Some participants in this sector are engaged in illegal activities such as
gambling, prostitution, the narcotic trade and so forth. Persons receiving income or not
fully report their incomes to the Interval Revenue Service.

In other words, the existence of underground economy distorts the basic economic
indicators such as GNP and the unemployment rate because GNP is understated and
our official unemployment statistics will be overstated and this may pose a problem for
policy makers. I.e. understate GNP and overstate unemployment rate might prompt
policy makers to stimulate the economy but the stimulus may cause unwanted inflation
rather than increases in real output and employment rate

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2. 5. Nominal GDP versus Real GDP
Dear Learners!!

In the previous lessons, you explored the basic concepts of GNP/GDP. You also
discussed the ways how to measure the national output. However, you didn’t take the
effect of price change on the national output measurement. The purpose of this lesson is
therefore to explore the impact of price change on the national output.
What is the difference between nominal GDP and real GDP?
In measuring GDP, we use prices to measure the value of good and services produced.
Using the current prices to value current production is known as nominal GDP. The
problem with nominal GDP is that a change in nominal GDP can be due to either (1) a
change in the production of goods and services, or (2) a change in the prices of those
goods and services or (3) a change in both the price and the production of goods and
services.

So, an increase in prices will cause nominal GDP to rise, even if production has not
changed at all. This gives a misleading picture of how well our economy is doing. It also
makes it difficult to compare production from year to year, since prices change every
year. To address the price problem, we also construct a measure of GDP that takes price
changes into account.

Real GDP values goods and services in any given year by using the prices of a set base
period. By holding prices constant, real GDP measures only the changes in production
from year to year. Changes in real GDP are used to measure economic growth. We
choose a base year for measuring real GDP.

For years closer to the present than the base year, real GDP tends to overstate rates of
economic growth. For years further in the past than the base year, real GDP tends to
understate rates of economic growth. To make clear, let see the prices and production
level of three different commodities. The economy produced only these three goods for
three consecutive years. The production level and the market price of the commodities
are as follow:

Table 2. 5. Economy producing three goods in three different years

Year Apples Computers Pizza
Price Quantity Price Quantity Price Quantity
1997 $0.45 475 $1100 70 $7 380
1998 $0.48 510 $1050 85 $8 390
1999 $0.50 500 $1000 100 $9 400

While calculating the nominal GDP for each year, it must be taken the current quantity
produced and the current market price charged on the produced commodities i.e.
nominal GDP for each year equals the price for that year times the quantity for that
year.

Nominal GDP1997=(0.45)(475)+ (1100)(70) + (7)(380) = $ 79,873.75

Nominal GDP1998=(0.48)(510)+ (1050)(85) + (8)(390) = $ 92,614.80
Nominal GDP 1999 = (.50)(500) + (1000)(100) + (9)(400) = $103,850
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Nominal GDP increment from 1997 to 1999 is

This 30.02 percent increment is because of the change in the market price and the
change in the production. In this case, we can’t say this is due to the production
improvement and price increment. We can’t also single out the separate effect price and
production on the change of nominal GDP. In order to know this effect, let’s calculate
the real GDP of each year using the base year of 1998.

Real GDP 1997 = (.48)(475) + (1050)(70) + (8)(380) = $ 76,786

Real GDP 1998 = (.48)(510) + (1050)(85) + (8)(390) = $ 92,614.80
Real GDP 1999 = (.48)(500) + (1050)(100) + (8)(400) = $108,440

Real GDP has increased from 1997 to 1999 by approximately 41 percent. But this
increase includes ONLY changes in production, because prices are held constant at their
1998 levels. Note how the real GDP increase is greater. This is because in calculating
nominal GDP, computer prices are falling over time even though computer production
is increasing. Real GDP = nominal GDP in the base year, since both measures use the
same prices and same production. Growth rate of RGDP

Associated with the nominal and real GDP, there is an important measurement unit,
which is known as the GDP Deflator. GDP Deflator measures general price level
increases in all assets rather than some particular subset. The term “deflator” in this
case means the percentage to reduce current prices to get the equivalent price in a
previous period. It is the ratio of nominal to real GDP:
Nominal GDP
GDP Deflator =
Real GDP
Illustration: suppose the nominal GDP of a hypothetical economy in year 2000 is USD
4900. Calculate the GDP Deflator of the goods and services if the overall increment in
the prices of goods and services produced in the economy (rate of inflation) is 10
percent.

The GDP deflator is the ratio of nominal to real GDP, from the given data nominal
GDP =$4900, but real GDP is not given; hence we need determine first real GDP
before going to the computation of GDP deflator. From the data we know that, there is
10% inflation in the economy. Hence, real GDP is obtained as:
Real GDP = (Nominal GDP – (Nominal GDP) (rate of inflation))
= $4900 – ($4900) (0.1)
=$4900 - $490
=$4410
Nominal GDP
Thus, GDP Deflator = = $4900/$4410= =1.11=111 percent
Real GDP

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Summary
National income accounting refers to a nation’s economic performance. Macro data such
as income, output, price, employment, and so forth can be measured using various
measurement units. GNP, GDP and other social accounts (NNP, NI, PI, PDI, and such
forth) are some of the commonly parameters to measure macro output.

Gross national product is the value of output produced by factors of production owned
by residents of the country. GNP differs from GDP both because some goods made in
the country are produced by foreign-owned factors of production and because our
citizens receive income from abroad, for example, if they own assets abroad.

Nominal gross domestic product is the value, measured at market prices, of the output
of final goods and services produced within the country. Real GDP is the value of the
economy’s output measured in the prices of some base year. Real GDP comparisons,
which are all based on the same set of prices for valuing output, provide a better
measure of the change in the economy’s physical output than nominal GDP
comparisons, which also reflect inflation.

Review Questions
1. Suppose that the Ethiopian economy produced only good X and Good Y. the total
production of the two goods are given in the following table. Assume again that the
economy uses the year 1990 as the reference (base) year for the subsequent years.
Calculate GDP at constant price of 1990 for year 2000. What is the percentage growth
in nominal GDP between the two years? What is the percentage growth in real GDP
between 1990 and 2000?

Goods Nominal 1990 Nominal 2000

Quantity Price Quantity Price

Good X 100 ETB 4 120 ETB 5

Good Y 150 ETB 3 160 ETB 2
GDP

2. Assume that the GDP of Ethiopia is four times as large as GDP of Kenya. Can we
conclude, based on the information, that the average per capita income of Ethiopian is
four times as well of as the average per capita income of Kenyan? Why or Why not

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3. Suppose that the government gives a firm, say, $7.00 for each unit of product the
firm sells that is a subsidy. Assume again that the selling price is $100.00 per unit. What
is the amount (the value of the output) recorded in the expenditure side? What about in
the income side? What is the total sales revenue before and after the subsidy?

4. Suppose a hypothetical economy has exhibited the following economic performance

indicators including on major components of GNP as measured on current value of birr.
Hence, based on these data, calculate the value of gross national product (GNP), the net
national product (NNP), the amount of government and business transfer, and the
disposable personal income.

Gross domestic product $4900 Social security $450

contribution
Net factor payment from abroad $10 Dividends $200
Capital consumption allowance 10% of GNP Interest adjustment $150
National income $3700 Personal income $3500
Corporate profits $350 Personal tax and $1100
non-tax payments

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