Chapter-2: National Income Accounting

Contents:

2.1. The Concept of GDP & GNP

2.2. Approaches of Measuring National Income(GDP/GNP)

2.3. Other National Accounts (GNP, NNP, NI, PI, DI)

2.4. Nominal vs Real GDP

2.5. The GDP Deflator ,Consumer Price Index and Inflation

2.6. Inflation & Unemployment

1
….Ch-2: National Income Accounting…cond.
Measuring the value of economic activities (=Output)

- Gross Domestic Product (GDP)-is the market value of all final goods &
services produced within a country’s domestic territory regardless of the
producer’s nationality in a given period of time.

- There are three ways to view GDP statistic, that is:

i. as total output/production in an economy during a given period,
ii.as the total income of everyone in the economy,
iii. as total expenditure on the economy’s output of goods and services.

- GDP figures tells us about the level of income & expenditure at a time
since one person expenditure is the income of another person and vice-
versa,

- To measure GDP, we use market prices because, it the amount people

are willing to pay for different goods, they reflect the value of those goods.
2
 … Measuring the Value of Economic Activity:
Gross Domestic Product…cond.
Income, Expenditure, and the Circular Flow Model : Two Markets – Two Agents

There are 3 ways

Total income of everyone in the economy
of viewing GDP

GDP measures the

flow of money like Total output
Birr/Dollars etc in (production) in
the economy. the economy

Total expenditure on the economy’s　output of goods and services 3

 … Measuring the Value of Economic Activity:
Gross Domestic Product…cond.
Income, Expenditure, and the Circular Flow Model : Three Markets – Three Agents

Labor Market hiring

work

Financial Market
saving borrowing borrowing

Households Government Firms

production
government
consumption spending investment

Goods Market
4
 … Measuring the Value of Economic Activity: Gross
Domestic Product…cond.

Precise Definition GDP from UN Statistics Division

- Gross domestic product- is an aggregate measure of
production equal to:
• the sum of the gross values added of all resident
institutional units engaged in production (plus any taxes,
and minus any subsidies, on products not included in the
value of their outputs).

• The sum of the final uses of goods and services (all uses
except intermediate consumption) measured in
purchasers' prices, less the value of imports of goods and
services, or
• the sum of primary incomes distributed by resident
producer units.
5
 Rules for Computing GDP

Some questions on what GDP should constitute and should not Constitute

When calculating GDP from expenditure side, should we include transaction

of used goods?

Should we include inventory?

Do you think GDP increases if we repeat the transaction of one goods

between the same people?

Is it true that even if I own my house, the rent for my house is counted as a
component of GDP?

Suppose a firm produces $10 million worth of final goods, but only
sells $9 million worth. Does this violate the expenditure = output
identity?
6
 …Rules for Computing GDP…cond.

• Combine the value of various goods and services produced in an

economy(using the market value of the respective item) in determining
GDP,
- Ex: Suppose an economy produces 4-Apples, 3-Oranges and 2-
haircuts, during the year 2015, with the respective per-unit market
price of: Apples= $0.5; Orange =$1, and that of haircut is $2.5.

What is this GDP of this economy for the year 2015?

Answer: GDP = (4 Apples x $0.2) + (3 Oranges x$1) + 2 Haircuts x

$2.5) = $10

7
 …Rules for Computing GDP…cond.
• Treatment of Used Goods- GDP measures the value of currently
produced goods and services. Hence,
ü transaction values related to a simple transfer of asset (like
reselling an item bought earlier from the producer) do not
constitute any addition to an economy, and here be excluded from
GDP.
For instance:
o When a farmer sale cotton for a merchant for 200 birr, that 200
birr is added to the nation’s GDP (b/s the farmer produce an
additional birr 200 worth of Cotton for the economy),

o However, the resale of cotton by the Merchant reflects the

transfer of an asset, not an addition to the economy’s income.
8
 …Rules for Computing GDP…cond.
• The Treatment of Inventories: Imagine that a bakery hires workers to produce more
bread, pays their wages, and then fails to sell the additional bread.
How does this transaction affect GDP?
Two possible ways depending on what happens to the bread. These are:
i. If the bread is spoils, neither total expenditure nor total income in the economy will
be affected in this case.
o Economy wide total income remain unaffected, though, the income of workers
receiving wage increase, while the income of the firm(its profit decrease by the
same amount) offsetting each other, and
o Total Expenditure remain the same, b/s no one spent on the bread( rather, it is
spoiled).
ii. If the bread is put into inventor, instead, to be sold later, then:
o The owners of the firm are assumed to have “purchased’’ the bread for the
firm’s inventory, w/c increases the expenditure in the economy,
o The additional wage increase to workers increase the income in the economy
o Hence, this transaction increases GDP of the period. 9
NB: The resale of the bread by the firm in later time is simply treated as sale of a used good, and, hence do not affect GDP.
 …Rules for Computing GDP…cond.
• Intermediate Goods and Value Added: Many goods are produced in
stages:
o raw materials are processed into intermediate goods by one firm
and then sold to another firm for final processing,
How should we treat such products when computing GDP?

o For example, suppose a cattle rancher sells one-quarter pound of

milk to Diary shop for 2 birr, and then the owner of the shop sells you
butter for 3 birr.
Should GDP include both the butter and the milk (a total of 5 birr), or just
the butter (3 birr)?
o The answer is that GDP includes only the value of final goods.
o Thus, the butter is included in GDP this time, but the milk is not: Hence,
o GDP increases by 1.birr, not by 3.00 birr.
o The reason are that the value of intermediate goods is already included as part of
10
the market price of the final goods in which they are used,
 …Rules for Computing GDP…cond.
… Intermediate Goods and Value Added…cond.

ü To add the intermediate goods to the final goods would be double

counting—that is, the milk would be counted twice,

ü One way to compute the value of all final goods and services is to sum
the value added at each stage of production,

ü The value added of a firm equals the value of the firm’s output less
the value of the intermediate goods that the firm purchases,
ü In the case of the milk, the value added of the rancher is 2 birr
(assuming that the rancher bought no intermediate goods), and the
value added of butter is birr 1.00.Total value added is 2 birr + 1birr,
which equals 3 birr.

ü Therefore, for the economy as a whole, the sum of all value added must
equal the value of all final goods and services,

ü Hence, GDP is also the total value added of all firms in the economy.
11
 …Rules for Computing GDP…cond.
• Treatment of Housing Services and Other Imputations:
ü Some goods and services may not be sold in the market place,
ü Hence, they may not have market prices,
ü To include such goods & services in GDP estimation, we must use an estimate of
their value,
ü Such an estimate is called an imputed value.
Example of such goods include:
Ø Housing Service
üthough some people rent house(expenditure) and pay to landlord(income), many
people still live in their own house. To account for own house service, we impute its
value by using the rental price of similar house in the economy,
Ø valuing government services
ü to value gov’t services like police officers, firefighters, and others, we can impute the
price of such services using the wages of these public servants as a measure of the
value of their output.

12
 …Rules for Computing GDP…cond.
Note:
ü In practice, applying imputation is not possible for all goods services(like
meals cooked at home, jewelry etc).

üNo imputation is made for G&S produced and sold in underground

economy(like illegally activities). goods & services

üB/s imputations(if applied are simply approximation), and the value of many
goods and services are total left out in calculating GDP, GDP is a an
imperfect measure of nations economic performance, w/c makes
comparison of countries economy very challenging,

üYet, as long as the magnitude of these imperfections remains fairly constant

over time, GDP is useful for comparing a country’s economic activity from
year to year.
13
 2.2. Approaches of Measuring National Income(GDP/GNP)
• There are three approaches to measuring GDP. These are:
i. Income Approach
ii. Expenditure Approach
iii. Value Added Approach.

2.2.1. Income Approach

• As shown in the circular flow model, the returns (income) to factors of production such as
labor, Land and capital sum up together to arrive at the amount of output produced in a
given economy per unit of time,

• In this approach, depending up on the owner of factor input, the components of GDP may
include:
ü Employment compensations payment made for labor in the form of wages and
salaries,
ü Rents payments for use of land, building and other capital input,
ü Interest income received by households on their saving deposit,
ü Profit payments made to the owner of firms in return to the output produced after
deduction of cost of production. 14
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.

…Income Approach…cond.

• Aggregating together the above returns to factor input will gives national income
of an economy.

• So, to arrive at GDP, indirect business tax and depreciations are added to
national income,

Ø Depreciation represents consumption of fixed capital which can be

considered as cost of production,

Ø Indirect business tax such as sales taxes are payments that represent the
difference between what buyers pay for final product and what users
receives from excise and sales taxes,
o It is the income generated through production process but not earned by
factor owners,
Ø Hence, indirect business tax and depreciation enter the income side in the
15
process of GDP computation.
 2.2. Approaches of Measuring National Income(GDP/GNP…cond.

…Income Approach…cond.
• The following table represents an example of GDP
computation for hypothetical economy using income
approach,
Table 2.1. GDP of hypothetical economy in billions of dollars

16
 2.2. Approaches of Measuring National Income(GDP/GNP)

2.2.2. Expenditure approach

• Alternative to income approach, the value of total output in the

economy can be measured by aggregating expenditure made on final
goods and services in the product market,

• Such approach of measuring GDP is known as expenditure approach,

• 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 as shown in the diagram on the next slide.
17
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.

…Expenditure Approach…cond.

The Components of Expenditures

GDP
= Total output/production
= Total Income
= Total Expenditure Net exports

Consumption Government
spending by purchases
households

National income accounts identity- i.e. equations that

must hold because of the way the variables are defined. 18
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.

…Expenditure Approach…cond.
Components of Consumption(C)- consumption consists of
the values of all goods and services bought by
households,
o It is divided into three subcategories: nondurable goods,
durable goods, and services.

i) Durable goods - are goods that last a long time, such as cars, TV, various
home appliances etc,
ii) Nondurable goods- are goods that last only a short time, such as food and
` clothing and the like,
iii) Services- include the work done for consumers by individuals & firms, such
19
as haircuts, doctor visits, air travel and so on.
 2.2. Approaches of Measuring National Income(GDP/GNP)
…Expenditure Approach…cond.
Example: U.S. consumption, 2008

percentage
　 billions of US＄
of GDP
Personal consumption 10,129.90
70.1%
expenditures
Goods 3,403.20 23.6%
Durable goods 1,095.20 7.6%
Nondurable goods 2,308.00 16.0%
Services 6,726.80 46.6%

20
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.
…Expenditure Approach…cond.

Source: NBE Annual Report-2014/15

21
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.

…Expenditure Approach…cond.
Investment (I)
Investment: Consists of spending on [the factors of
production], and/or spending on goods for
future use.
o Investment is also divided into three subcategories as:
i) business fixed investment- Spending on/purchase of/
plant and equipment that firms will use to produce
other goods & services.
ii) residential fixed investment- Spending on/purchase of/
housing units by consumers and landlords,
iii) Inventory investment- The change(increase) in the value
of all firms’ inventories of goods. If
inventories are falling, inventory
investment negative/disinvestment).22
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.

…Expenditure Approach…cond.

Source: NBE Annual Report 2014/15

23
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.

…Expenditure Approach…cond.
U.S. investment, 2008
percentage
　 billion of $
of GDP
Gross private domestic 2,136.10
investment 14.8%

Fixed investment 2,170.80 15.0%

Nonresidential 1,693.60 11.7%
Structures 609.5 4.2%
Equipment and software 1,084.10 7.5%

Residential 477.2 3.3%

Change in private inventories -34.8 -0.2%

24
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.
…Expenditure Approach…cond.
Note: Difference b/n Investment vs. Capital

ü Investment- is spending on new capital.

It is a flow concept- w/c is a
quantity measured per unit of
time.
E.g., “U.S. investment was $2.5 trillion during 2006.”

ücapital -is a stock concept- w/c is a quantity

measured at a point in time.
“The U.S capital stock was $26 trillion on January 1, 2006.”

Example (assumes no depreciation):

– 1/1/2006:
economy has $500b worth of capital
– during 2006:
investment = $60b
– 1/1/2007:
economy will have $560b worth of capital 25
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.
…Expenditure Approach…cond.
Government purchases (G)

• Government purchases(G)- includes all Summary of General Gov’t Expenditure of Ethiopia

federal, state and local gov’t spending on

goods & services (like highways
construction, service provided by gov’t
worker etc),

• Government Purchase(G)-does not include

transfer payments to individuals, such as
Social Security and welfare,

Ø Because transfer payments reallocate

existing income and are not made in
exchange for goods & services, they
are not part of GDP.
26
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.
…Expenditure Approach…cond.

U.S. government purchases, 2008

percentage
　 billion of $
of GDP
Government consumptio 2,883.20 20.0%
n expenditures and gross
investment

Federal 1,082.60 7.5%

National defense 737.9 5.1%
State and local 1,800.60 12.5%
27
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.
…Expenditure Approach…cond.
Net exports(NX) – is the total value of total exports(EX) minus the value
of total imports(IM) , or EX= EX – IM

Components of External Trade as Percentage of GDP Trends in Components of Current Account

28
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.
…Expenditure Approach…cond.
• In summary, a GDP computation based expenditure approach could be done by
adding expenditures made on output produced in a given economy during a given
period. An illustration of this is given below using the product side of 1987 USA GDP
with its components
GDP and it components, in $ billions in 1987 for USA

29
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.

2.2.3. Value added (Product) Approach

• Production of goods & services typically involves a sense of distinct stage,

• Each stage involves separate market transaction and flow of income,

• For example as indicated in table on the next slide, there are four different
stages having their own market transaction in production of bread,
1. The farmers first grow up the wheat, and then sold to the Mill owners,
2. Then the mill owner converts the wheat to flour and sell to bread beaker,
3. The bread baker sell the bread to the store owner,
4. The store owner sell the bread to consumer finally.
• The value of the final goods already includes the value of the intermediate
goods, so including intermediate and final goods in GDP would be double-
counting.

• A firm’s value added is the value of its output minus the value of the
intermediate goods the firm used to produce that output.
30
 2.2. Approaches of Measuring National Income(GDP/GNP)…cond.

…Value added (Product) approach…cond.

Production of bread involving four different stages

Note:

o The value of the final product(bread) is equal to $0.75, and this is exactly equal to the sum of
all value additions at each stage of production (i.e. $0.75 = $0.12+ $0.16 + $0.32 + $0.15).

o Hence, the final value of the bread is $0.75, not $1.75(w/c exaggerated due to inclusion of
intermediate goods in to the value of final good(bread)-a double counting problem).

o Hence, in value added approach, we need carefully different b/n final and intermediate goods
31
in calculating GDP.
 2.3. Other National Accounts (GNP, NNP, NI, PI, DI)
Alternative to GDP, other measures are used to represent the total output produced in an
economy includes:
o Net domestic product (NDP) –It represent the value of total output of an economy
after net out depreciation, i.e. NDP=GDP – depreciation.

o Net national product (NNP)-measures the value of total output produced by a citizen
of a given country within a specified time period after subtracting the consumption of
fixed capital (depreciation) i.e. NNP=GNP – Depreciation.

o National Income (NI) – It is the total income earned by resource owner from current
production, w/c can be computed in two ways:
i. First, by summing up the factor incomes earned in producing total output,
i.e. NI=wages and salaries + proprietors income + Rental income
+corporate profit +Interest income.
i. Second, by making adjustment to NNI through subtracting indirect business
tax,
ii. i.e. NI= NNP-Indirect business tax (e.g. sales tax) ; or

NI= GNP - Depreciation – Indirect business tax. 32

 …Other National Accounts (GNP, NNP, NI, PI, DI)…cond.

o National income(NI)- can be also determined from NDP after making

adjustment for indirect business tax and net foreign income i.e.
NI= NDP-Indirect business tax + Net foreign factor income.

o Net foreign factor income(NFFI)- income earned by domestic citizen abroad in

return to factors input minus incomes generated by foreigners found in
domestic economy in return to their factor input i.e.

ü Add factor payments received from abroad(NFFR) by domestic

citizens/factors of production/
ü Subtract factor payments made to foreign citizens/factors(NFFP) of
production from domestic production/sector/.
ü NFFI = GNP – GDP ; or, GDP = GNP-NFFI ; or GNP = GDP + NFFI
ü If NFFP > NFFR, then, NFFI will be negative, and GNP will be less than
GDP; and vice-varsa.
33
 …Other National Accounts (GNP, NNP, NI, PI, DI)…cond.

• Personal income- is the amount of income that households & non corporate
businesses receive,
• It can be obtain from national income(NI) after series of adjustments:
ü First, reduces from the national income by the amount of corporate
earnings, but add payments to its share holders (retained earnings & taxes
i.e. income earned but not received),
ü Secondly, increase the national income by the amount government &
businesses pay transfers to individuals (income received, but not earned),
ü Thirdly, national income(NI) is adjusted for interest rate that households
earn rather than interest rate paid by firms,

Personal income (PI) = National Income(NI)

- corporate profit & Gov’t Income
- Social Insurance contributions.
- Net interest received by corporate +
+ Personal Dividend Income
+ Government transfer payment to persons
+ Business Transfer Payments to Persons
+ Personal interest income 34
 …Other National Accounts (GNP, NNP, NI, PI, DI)…cond.
• Disposable personal Income(DI)- is
Households’ non corporate business
Computation of other measures of economic activities by making possible on GDP

income that is available for spending

after tax & non tax payments are
deducted,
i.e. Disposable income (DI)
= personal income
- Personal tax
- other non-tax payments.
• Disposable income(DI) would be either
consumed or saved, i.e.
DI = Consumption(C) + Saving(S)

• The table on the right shows the

necessary adjustment that should be
made to arrive at disposable income
starting from GDP.
35
 Problems of GDP Measurements
The following are some of the problems related to GDP calculation which in turn may result in Over and
understatement of welfare,
Ø Double counting,
Ø Non Productive transactions such as the following are excluded from GDP:
- Public Transfer Payments
• Unemployment compensation
• Welfare payments to the poor and Social Security
• Subsidy
- Individual or Private Transfer Payments
- Non marketed outputs such as:
• Cost of goods for some goods (e.g. government produced public goods, roads, hospitals
whose value may not be easily estimated etc)
• Household outputs and services (for own consumption purpose)
• Illegal goods and services
Ø Informal Sector or the Underground Economy are also excluded, no data,
Ø Production of ‘bads’ such as pollution are not included,
Ø Other economic transaction not included in GDP measurement
• The buying & selling of intermediate goods,
• The buying and selling of used items (goods),
• The buying and selling of financial securities.
Note: GDP consists of the value of output currently produced . It thus excludes transactions in existing commodities,
such as old masters or existing houses. We count the construction of new houses as part of GDP, but we do not add
trade in existing houses. We do, however, count the value of realtors’ fees(such as agents/brokers’ fees) in the
sale of existing houses as part of GDP. The realtor provides a current service in bringing buyer and seller together, and
that is appropriately part of current output. 36
 2.4. Nominal vs Real GDP
• GDP is the value of all final goods and services produced,

ü Nominal GDP- measures these values using current prices,

(i.e. Nominal GDP = Current Price Level(P) X Actual output level) .

o Nominal GDP can change due to:

Ø change in the amount (real value) of goods & services, and/or
Ø change in the prices of those goods and services.

ü Real GDP-measure these values using the prices of a base year (i.e.
Real GDP = Actual Output of current period/year X Base year price).
o Real GDP is a better measure of country’s economic wellbeing as it changes
only due to change in real out put of goods and services.
o It is not influenced by price changes since constant/base year price is used in

this case.
• For this purpose, economists usually use real GDP, to analyze country’s economic
wellbeing,
• This distinction between real & nominal can also be applied to other monetary
37
values, like wages, interest rate, money supply and demand etc).
 …Nominal vs Real GDP…Cond.
Illustration:
To see how real GDP is computed, imagine we wanted to compare output in 2002 and
output in 2003 in an economy that produces two goods(apple & orange) and one
service(haircut) during these years. 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:

(2002 Price of Apples  2002 Quantity of Apples) + (2002 Price of Oranges 

2002 Quantity of Oranges) + (2002 Price of haircut  2002 Quantity of haircut).

Real GDP in 2003 would be:

(2002 Price of Apples  2003 Quantity of Apples) + (2002 Price of Oranges 
2003 Quantity of Oranges) + (2002 Price of haircut  2003 Quantity of haircut) .

Real GDP in 2004 would be:

(2002 Price of Apples  2004 Quantity of Apples) + (2002 Price of Oranges 
2004 Quantity of Oranges)+ (2002 Price of haircut  2004 Quantity of haircut).
38
 …Nominal vs Real GDP…Cond.
Note:
ü In computing Real GDP, the 2002 prices are used for all three years, b/s the
2002 prices are taken as base year(constant price),
ü Hence, real GDP varies from year to year only if the quantities produced
vary(since prices are held constant),
ü 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.
Example:

2006 2007 2008

P Q P Q P Q
good A $30 900 $31 1,000 $36 1,050
good B $100 192 $102 200 $100 205

39
 …Nominal vs Real GDP…Cond.

i) Compute nominal GDP in each year.

ii) Compute real GDP in each year using 2006 as the base year.
Answer:

Nominal GDP - multiply Ps & Qs from same year

2006: ($30  900) + ($100  192) = $46,200
2007: ($31X1000) +($102x200) = ($51,400
2008: $36 X 1050) + $100 X 205) =$58,300

Real GDP - multiply each year’s Qs by 2006 Ps

2006: ($30  900) + ($100  192) = $46,200
2007: ($30X1000) + ($100 X200) = $50,000
2008: = $30  1050 + $100  205 = $52,000

40
 …Nominal vs Real GDP…Cond.
Chain-Weighted Measures of GDP
o One problem with traditional “real GDP” calculations is that, since it values all
goods at base year prices, it looks like prices never change,

o As time goes on, goods whose prices go down (and quantities usually go up)
are still weighted by the old prices, and consequently get too much weight in
later years’ GDP calculations,

o The goods don’t require a large expenditure share, but if they are valued at
base year prices, it would look like a spuriously high share of GDP.

o Hence, since relative prices change over time, so the base year should be
updated periodically,

o In essence, Chain-weighted real GDP calculation method updates the base

year every year, and hence it is more accurate than constant price-real GDP.

o Yet, the traditional method is still widely used because:

– the two measures (nominal & real GDP) are highly correlated,
– constant-price real GDP is easier to compute. 41
 …Nominal vs Real GDP…Cond.
…Chain-Weighted Measures of GDP…Cond.
Example:
Suppose people only consume 3 different goods. The following table shows the
prices and quantities of each good consumed in 2006, 2007, and 2008.

Required:
i) Calculate nominal GDP in each of the three years.
Nominal GDP is simply equal to the sum of the current year price * current year quantity
of all the goods.
Year-2006: (7*400) + (8*225) + (10*175) = 2,800 + 1,800 + 1,750 = $6,350.
Year-2007: (8*550) + (7*250) + (12*275) = 4,400 + 1,750 + 3,300 = $9,450.
Year-2008: (9*900) + (6*275) + (15*275) = 8,100 + 1,650 + 4,125 = $13,875.

42
 …Nominal vs Real GDP…Cond.
…Chain-Weighted Measures of GDP…cond.
ii) Calculate Real GDP in each of the three years, using 2006 as the base year(traditional
method).
Real GDP is equal to the sum of the base year price * current year quantity of all the goods.
Year-2006: (7*400) + (8*225) + (10*175) = 2,800 + 1,800 + 1,750 = $6,350.
Year-2007: (7*550) + (8*250) + (10*275) = 3,850 + 2,000 + 2,750 = $8,600.
Year-2008: (7*900) + (8*275) + (10*275) = 6,300 + 2,200 + 2,750 = $11,250.

iii) Calculate Real GDP for 2007 and 2008 using the chain-weighted method.
o Using 2006 as the base year, we know that Real GDP is equal to nominal GDP. Thus
Real GDP in 2006 is $6,350. This gives us the starting point for the chain-weighted
method of calculating real GDP.
o To calculate chain-weighted Real GDP for 2007 we need the following four pieces of
information:
ü Year- 2006 quantities at 2006 prices: See part-i above, $6,350.
ü Year-2007 quantities at 2006 prices: See part-ii above, $8,600.
ü Year-2006 quantities at 2007 prices: (8*400) + (7*225) + (12*175) = $6,875.
ü Year-2007 quantities at 2007 prices: See part-i above, $9,450.

o Now, we calculate the growth rate of GDP using 2006 prices: (8,600 – 6,350)/6,350)*100 = 35.4%,
o Then, the growth rate of GDP using 2007 prices: (9,450 – 6,875)/6,875)*100 = 37.5%.
43
 …Nominal vs Real GDP…Cond.

…Chain-Weighted Measures of GDP…cond.

• The next step is to average the two growth rates as: (35.4 + 37.5)/2 = 36.45%.
This gives us the chain weighted growth rate of real GDP for 2007.
• So, to calculate 2007 Real GDP we multiply 2006 real GDP by this growth rate
as: (6,350 + (6,350*36.45%)) = $8,664.6.

• Repeating the same process for 2008 gives us the following:

ü 2007 quantities at 2007 prices: See part a, $9,450.
ü 2008 quantities at 2007 prices: (8*900) + (7*275) + (12*275) = $12,425.
ü 2007 quantities at 2008 prices: (9*550) + (6*250) + (15*275) = $10,575.
ü 2008 quantities at 2008 prices: See part a, $13,875.
ü Growth rate with 2007 prices: ((12,425 – 9,450)/9,450)*100 = 31.5%
ü Growth rate with 2008 prices: ((13,875 – 10,575)/10,575)*100 = 31.2%
ü Average growth rate: (31.5% + 31.2%)/2 = 31.35%.
ü We use the chain-weighted 2007 GDP as our starting point, and get: (8,664.6 +
(8,664.6*31.35%) = $11,381.0.

44
 2.5. The GDP Deflator, Consumer Price Index(CPI) and Inflation
To measuring the price level, we usually use:
– GDP Deflator
– Consumer price index (CPI)

Changes in nominal GDP can be due to:

– changes in prices.
– changes in quantities of output produced.

Changes in real GDP can only be due to changes in quantities,

because real GDP is constructed using constant base-year prices.
– The inflation rate is the percentage increase in the overall level of prices.

– One measure of the price level is the GDP deflator, also called the implicit
price deflator for GDP,
– The GDP deflator reflects what’s happening to the overall level of prices in
the economy, and is defined as the ratio of nominal GDP to real GDP,

N om inal G D P
G D P deflator = 100 
R eal G D P 45
 …The GDP Deflator, Consumer Price Index(CPI) and Inflation…cond.

Illustration:
Ex-1: Consider our previous example of three different goods(fish, pork, and beef)
presented in the below table.

iii) Calculate the GDP Deflator for each of the three years using the information given in the
above information.
o The GDP deflator is equal to (Nominal GDP / Real GDP)*100.

o Year-2006: 100, because 2006 is the base year we know the deflator has to equal 100 even without doing any
calculations, since nominal GDP and Real GDP of the base year are exactly the same(equal).
o Year -2007: Nominal GDP 2007 / Real GDP2007* 100 = (9,450 / 8,600)*100 = 109.9.

o Year-2008: Nominal GDP 2008 / Real GDP2008* 100 = (13,875 / 11,250)*100 = 123.3 .
iv) Calculate inflation for 2007 and 2008.
o Inflation is equal to the growth rate of the GDP deflator.
o The growth rate formula is: ((Year2 –Year1)/Year1)*100.
o Year-2007: (109.9 – 100)/100)*100 = 9.9% - increase in general price level b/n 2006 & 2007.
46
o Year 2008: (123.3 – 109.9)/109.9)*100 = 12.2% - increase in general price level b/n 2007 &2008.
 …The GDP Deflator, Consumer Price Index(CPI) and Inflation…cond.

Ex-2: Compute GDP Deflator and Inflation for the years 2006 to 2008 .
GDP Inflation
Nominal GDP Real GDP
deflator rate
2006 $46,200 $46,200 n.a.
2007 51,400 50,000
2008 58,300 52,000

Use the information given in the above table and compute:

i. Compute the GDP deflator in each year.
ii. Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008.

Answer:

GDP Inflation
Nominal GDP Real GDP
deflator rate
2006 $46,200 $46,200 100.0 n.a.
2007 51,400 50,000 102.8 2.8%
2008 58,300 52,000 112.1 9.1% 47
 …The GDP Deflator, Consumer Price Index(CPI) and Inflation…cond.

Back of Envelop Calculation: Two arithmetic tricks for working with

percentage changes

For any variables X and Y,

1. Percentage change in (X  Y )  percentage change in X + percentage
change in Y

Ex: If your hourly wage rises 5% and you work 7% more hours, then
your wage income rises approximately 12%.
2. Percentage change in (X/Y )  percentage change in X  percentage
change in Y

Ex: GDP deflator = 100  NGDP/RGDP.

If NGDP rises 9% and RGDP rises 4%, then the inflation rate is
approximately 5% which is equal to 9% - 4%.

48
 …The GDP Deflator, Consumer Price Index and Inflation…cond.
Consumer Price Index (CPI)
• CPI- measure the current cost/price/ of a fixed basket of goods & services
purchased by a typical consumer relative to the same basket of goods and
services in some base year,

• It is the most commonly used price index to measure the general price level of
an economy,

• The Consumer Price Index (CPI) turns the prices of many goods and services
into a single index measuring the overall level of prices,
• The formula for calculating the price index is:
 cost of basket in current year 
CPI =    100
 cost of basket in base year 

• Inflation rate-is the percentage change in the price index from the
preceding period.
 C P I Year 2 - C P I Year 1 
in fla tio n ra te =    100% 49
 C P I Year 1 
 …The GDP Deflator, Consumer Price Index(CPI) and Inflation…cond.

How the CPI Basically Determined?

1. Survey consumers to determine composition of the typical consumer’s “basket”

of goods.
2. Every month, collect data on prices of all items in the basket; compute cost of
basket,
3. CPI in any month equals
Cost of basket in that month
100 
Cost of basket in base period

Example: Assume that consumer's basket contain two goods Pizza and Compact Disks.
Assume that the quantity consumed by a household during each period is 20 pizzas &
10 compact discs) as shown in the table below:
prices:
Year pizza CDs
2002 $10 $15
2003 $11 $15
2004 $12 $16 50
2005 $13 $15
 …The GDP Deflator, Consumer Price Index(CPI) and Inflation…cond.

Required: For each year, compute:

i) the cost of the basket for each year
ii) the CPI (use 2002 as the base year)
iii) the inflation rate from the preceding year
Answers:
ü Cost of basket in 2002 = ($20 * 10 pizza) + ($15 *10 disks) = $350
ü Cost of basket in 2003 = ($11*20 pizza) + ($15*10 disks) = $370
ü CPI in 2002 = 100 (for base year)
ü CPI in 2003 = (370/350) *100 = 105.7
ü Inflation in 2003 = CPI 2002 - CPI2003 = 105.7-100 = 5.7%

Note: Do the same thing for other years. The answer is given in the below table.
Cost of Inflation
basket CPI rate
2002 $350 100.0 n.a.
2003 370 105.7 5.7%
2004 400 114.3 8.1%
2005 410 117.1 2.5% 51
Trend of CPI and Inflation rate in Ethiopia-2016/17

Trend of Inflation Rate-Sep/2016- Oct/17

Trend of CPI-Sep/2016-Oct/2017

52
 …The GDP Deflator, Consumer Price Index(CPI) and Inflation…cond.

Problems in Measuring CPI:

Overestimation of Inflation- Reasons why the CPI may overstate inflation

– Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers’ ability to
substitute toward goods whose relative prices have fallen.

– Introduction of new goods: The introduction of new goods makes consumers better off and,
in effect, increases the real value of the dollar/birr; but it does not reduce the CPI, because the
CPI uses fixed weights.

– Unmeasured changes in quality: Quality improvements increase the value of the dollar/birr,
but are often not fully measured.

Producer Price Index (PPI)

o PPI- Measures the price of typical basket of goods bought by firms,
o It includes the cost of intermediate and final goods,
o The producer price index is believed to be helpful in predicting changes in the CPI.
53
 …The GDP Deflator, Consumer Price Index(CPI) and Inflation…cond.

CPI vs. GDP Deflator: Comparison

GDP Deflator CPI

Measure the prices of all goods
produced.
ü Hence, it include price of goods &
services bought by consumers, firms,
and gov’t.
ü Price of imported goods are excluded ü Price of imported consumer goods
because such prices are not part of
GDP.
ü Assign changing weight to the prices
of different goods & services(the
basket of goods are changing over
time).
ü The prices of capital goods are
included in GDP deflator (if produced
domestically).
Measures prices of only the goods and
services bought by consumers.
ü Hence, it does not include price of
goods & services bought by firms,
and gov’t.
could be included.
ü Assign fixed weight to the prices of
different goods & services (the
basket of goods are fixed over time).
ü The price of capital goods are
excluded from CPI.

54
 The Two Measures of Inflation Using GDP Deflator and CPI- (U.S. 1950-2005).
from 12 months earlier
Percentage change

55
 2.6. Inflation and Unemployment

In previous sections, we have seen how to measure the value of output produced in
an economy with different parameters such as GDP and others income measures,

In this section, we will consider other measures of performance of the economy such
as:
ü inflation
ü unemployment.

Inflation:
Ø Inflation- is defined as a sustained rise in the general level of prices,

Ø Two points about this definition need emphasis. These are:

• First, the increase in price must be a sustained one, and it is not simply a
once for all increase in prices.

• Second, it must be the general level of prices, which is rising; increase in

individual prices, which can be offset by falling in prices of other goods is
not considered as an inflation.
56
…Inflation and Unemployment…cond.

57
 …Inflation and Unemployment…cond.
Cause of inflation
(i) Demand pulls inflation –according to demand pull theory of inflation

inflation results from a rapid increase in demand for goods & services than supply of
goods and services (fixed level of goods and services supplied).

But, why aggregate demand may increase rapidly than aggregate supply? There are
two different views on this:
i) Classical View of Demand Pulls Inflation
ii) Keynesian View of Demand Pulls Inflation

i) Classical View of Demand Pull Inflation- inflation is the result of monetary

expansion

ü Increase in money supply → increase demand for new investment → rises aggregate
demand for goods & services → upward shift in aggregate demand curve(say from AD0
to AD1).
(see fig on the next slide)

58
 …Inflation and Unemployment…cond.

Fig. Demand Pulls Inflation

As shown in the fig above, at initial equilibrium price level (P0):

ü The Aggregate Supply(output)/AS/ is equal to Ῡ) (what producers can supply)

üThe Aggregate Demand(AD) or what firms & gov’t would like to purchase Y1 amount
of goods & services,
üThis create excess demand of Y1-Ῡ in the economy, and
üThis excess demand causes the overall price to rises from P 0 to P 1 , and cause
inflation in the economy.
59
 …Inflation and Unemployment…cond.

If excess supply of money could cause inflation, why government(Central Bank)

allow money supply to increase then?

o The central bank may expand money supply for various reasons such as:

ü to finance gov’t budget deficit by borrowing from the central bank(printing

money) perhaps as a last option), specially when it could not finance its
deficit by other options due to:

o difficulty of increasing the tax rate as it could hurt businesses and

could aggravate the problem,

o difficulty of borrowing either domestically or abroad by issuing

bonds(may be due to excess debt burden),

o Such condition results in inflationary situation by increasing money

supply. 60
 …Inflation and Unemployment…cond.
ii) Keynesian View of Demand Pull Inflation:

For Keynesians, increase in aggregate demand, w/c cause demand pull

inflation could also arise from many real factors such as:

Ø increase in consumer demand- for goods & services consumption,

Ø investment demand-businesses demand for input for investment,

Ø government expenditure-gov’t demand more goods & services to meet

civil & military requirements of the country,
Ø net export- more resources could be needed for international trade(export
& import)
Such increase in Aggregate Demand for goods & services could happen even
when the supply of money is constant according to Keynesian view.

61
 …Inflation and Unemployment…cond.
…Keynesian View of Demand Pull Inflation…cond.
Fig. Keynesian view of Demand-Pull Inflation
When the value of aggregate demand exceeds the
value of aggregate supply at the full employment level,
the inflationary gap arises,

The larger the gap between aggregate demand and

aggregate supply, the more rapid the inflation,

Given a constant average propensity to save, rising

money incomes at the full employment level would
lead to an excess of aggregate demand over
aggregate supply and to a consequent inflationary gap,

Thus, Keynes and his followers used the notion of

the inflationary gap to show an inflationary rise in
prices.

62
 …Inflation and Unemployment…cond.
…Keynesian View of Demand Pull Inflation…cond.

ü But, this time, much less is produced than in the previous shift( as diminishing returns might
also set in some industries), and the price level has risen from P2 to P3, a much higher
increase in price than in the previous shift,

The graph in the previous slide illustrate the Keynesian view of demand pull inflation, and
shows that:
ü increased employment results in increased aggregate demand (AD), which leads to
further hiring by firms to increase output,
ü Due to capacity constraints, this increase in output will eventually become so small
that the price of the good will rise,
ü At first, unemployment will go down, shifting AD1 to AD2, which increases demand
(noted as "Y") by (Y2 - Y1),
ü This increase in demand means more workers are needed, and then AD will be shifted
from AD2 to AD3,
ü This increase in price is called inflation.
63
 …Inflation and Unemployment…cond.

ii) Cost Push (supply side) factors

There are many supply side factors which cause a sustained rise in the general price
level(inflation),

üAt times, price may not decline, even though aggregate demand decline (ex. 1958
recession in western economies),

üThese days, many countries are experiencing stagflation ( a situation of high

inflation & high unemployment),

üThese conditions which are not demand side factors are explained by supply side
factors.

Cost push inflation- occurs when:

ü Cost of production increase( due to different factors), and

ü Structural bottlenecks cause firms to supply below existing demand or reduce the
supply of goods & services

64
 …Inflation and Unemployment…cond.

…Cost Push (supply side) factors…cond.

Now, let us consider AD-AS model to explain how the

above mentioned condition results in inflationary
conditions.

ü As cost of inputs(labor, capital, entrepreneurship

increase, firms’ profit margin go down),

ü Such rise in cost of production together with other

structural bottlenecks causes upward(left-ward) in
aggregate supply curve from AS to AS1 for a given
level of price (due to decrease in equilibrium output Fig: Cost Push Inflation

decrease from Y0 to Y1)

ü This results in excess demand over supply(i.e. Yo-Y2)

at initial equilibrium price level(P0),

ü This excess demand for goods & services push price

65
to increase from P0 to P1.
 …Inflation and Unemployment…cond.
…Cost Push (supply side) factors…cond.
There are many factors w/c causes cost push inflation. These includes:
o Increase in price of input like labor, oil and other raw material,
o The minimum wage legislation interventions in labor market(which set minimum
wage above equilibrium wage level),
o Shock in the supply of major commodities like consumption goods & industrial
inputs (like food items, oil, coal, steel, cement, basic chemicals etc),
o The rise in price may be also caused by supply bottleneck in domestic economy or
international events
e.g. the Sudden rise in the OPEC oil prices during1970s due to Arab-Israel
war can be cited as supply shock that causes inflation.
Note:
The standard theories of inflation discussed above may not be applicable to less developed economies as
they are based on assumptions and institutional settings of developed economies like:
Ø Balanced & integrated structure of the economy,
ØSmooth inter-sectoral flows of resources in response to market signals,
Ø Quick adjustment between consumption production and investment,
Ø Smooth and free play of market forces,
66
Ø Full employments of resources are assumed especially by classical economists.
 …Inflation and Unemployment…cond.
…Cost Push (supply side) factors…cond.
In contrast, with regard to institutional factors, less developed economies are characterized
by:
o highly fragmented market & market imperfection,
o immobility of factors input ,
o wage rigidities,
o high unemployment,
o sectoral imbalances( surplus in some sector &scarcity in the other sectors).

o As a result, many developing economies are characterized by high rate of inflation with large
scale of unemployment(stagflation),
oTherefore, anti inflationary policies based on the standard theories have very little impact to
reduce inflation in developing economies.
o Hence, it is important to identify the factors which result in inflationary condition in developing
economics before we design and implement anti inflationary policies,
o That is why a search for appropriate explanation to inflation in less developed countries led to
the emergence of a new school of economists called the structuralists theories of
inflation. 67
 …Inflation and Unemployment…cond.
…Cost Push (supply side) factors…cond.

According to the structuralist view, inflation in developing economies is caused mainly by the
structural imbalances in these economies.

The major structural imbalance includes:

o Food scarcity- due to reasons like poor agricultural technology,

o Resources imbalance – like surplus labor and extremely scarce capital, budget deficit
w/c cause gab b/n supply & demand for goods & services, etc

o Foreign exchange bottle necks- export are limited (due to limited exportable items,
high cost of production, low quality of export items, and low competitiveness; while
import is high. This cause huge trade deficit( Import > Export),

o Infrastructural bottle necks- inadequate & inefficient industrial infrastructures which

undermine the growth of industrial output, while the demand is rising.

68
 …Inflation and Unemployment…cond.

Economic Effect of Inflation

Generally, high inflation could have the following adverse effects on the economic
performance and thereby undermine social wellbeing:

o reduces real money balance or purchasing power of money, and

thereby reduce welfare of individuals,
o inflation decreases demand for money (cash holding) due to rise in nominal
interest rate, I= r+П ---------Fisher’s equation ,
Where I- nominal interest rate, r-real interest rate, П -expected
inflation.
ü Hence, most people start holding more durable goods(change in portfolio of
assets),
ü Such shift from money to consumer durable causes decline in economic growth
by reducing investment.
ü But, if the portfolio management shifts to capital goods, inflation increases
69
economic growth by initiating capital accumulation.
 …Inflation and Unemployment…cond.

…Economic Effect of Inflation…cond.

o reduces investment by:
ü increasing nominal interest rate, and
ü creating uncertainty about macroeconomic policies.
ü reduction in investment & consumer demand reduces output,
o increases uncertainties about macroeconomic policy and adversely affects the
public decision making ability,
o redistributes wealth among individuals(specially from the poor to the rich),
o hurts individuals with fixed income (like pensioners),
o High shoes leather cost – due to frequent travel to bank to withdraw money since
opportunity cost of holding money is high,
o High menu cost- the cost of frequently changing items price list at restraints, supermarkets
etc.
Note:
Some economist believes that moderate level of inflation (2 to 3) percent per year is good to stimulate
70
the economy. Yet, what is moderate level may depend on countries specific situation.
 Stagflation
q Until the 1970s, many economists(Keynesians) believed that there was a
stable inverse relationship between inflation and unemployment,

q They believed that inflation was tolerable because, it leads to higher

economic growth and lower unemployment in such a way that:
ü increase in money supply increase in demand for G & S
Derive up price encourage firm to expand hire additional
workers create additional demand throughout the economy.

q In the 1970s, Keynesian economists had to reconsider their beliefs as the U.S.
and other industrialized countries entered a period of Stagflation- defined as a
simultaneous incidence of:
ü Slow economic growth
ü high unemployment,
ü High inflation rate.
q The US economy in 1970s was largely characterized
ü High oil price
ü Inflation
ü Unemployment 71
ü Recession.
 Hyperinflation
q def:   50% per month
q All the costs of moderate inflation described German Hyperinflation
above become huge under hyperinflation.
q Money ceases to function as a store of value,
and may not serve its other functions (unit of
account, medium of exchange).
q People may conduct transactions with barter
or a stable foreign currency.
What causes hyperinflation?
¡ Hyperinflation is caused by excessive
money supply growth:
¡ When the central bank prints money, the
price level rises.
¡ If it prints money rapidly enough, the
result is hyperinflation.

72
 Hyperinflation…cond.
Money and Prices in Brazil, 1985-
1995 Consumer Prices in Zimbabwe, 1999-2008

73
 Deflation vs Disinflation
q Deflation- is a decrease in the general
price level of goods and services,
q Deflation occurs when the inflation
rate falls below 0% (a negative inflation Japan’s Lost Decade: Deflation
rate say -1%, -2% etc),

q Inflation reduces the real value of

money over time, but deflation
increases it,
q This allows one to buy more goods and
services than before with the same
amount of money,

q Deflation is distinct from disinflation, a

slow-down in the inflation rate (say from
9% to 7%), i.e. when inflation declines
to a lower rate but is still positive.
74
 …Inflation and Unemployment…cond.

Measures to control inflation

Economists agree that inflation beyond a certain level is bad and causes
different type of disasters to the economy,

Therefore, it should be controlled by using appropriate mix of fiscal and monetary

policies,
However, following the controversy on:
ü what cause inflation,
ümethods to control inflation,

ü effectiveness of fiscal and monetary policies in the policy mix.

Hence different group of economists prescribe d/t policy approach. For instance:
üMonetarists - recommend more of monetary measures,
üKeynesians/Fiscalists- suggest more fiscal measures(like tax and gov’t
expenditures), 75
 …Inflation and Unemployment…cond.

…Measures to control Inflation…cond.

Generally, the following policy measures are used in combination to
control inflation.
o Monetary measures- control of money supply through appropriate
monetary policy (Bank rate, reserve requirement ratio, open
market operation) greatly effective in controlling inflation,
o Fiscal measures-controlling aggregate demand using fiscal policy
tools using tax and gov’t expenditures.
o wage and price control- introduce price & wage control measures to
control cost push inflation (where monetary & fiscal policies are
ineffective),

76
 …Inflation and Unemployment…cond.

Unemployment
As discussed in the preceding chapter, ensuring full level employment
is one of the major macroeconomic goals,
Unemployment- is a situation in which able bodied persons willing to work at
prevailing wage rate do not able to find job,
People in economically active age group are divided in to three major
categories: These are:
i. Employed- working at a paid job or self employment,
ii. Unemployed- not employed, available for work, looking for work,
iii. Not in labor force- not employed, not looking for work.

Labor Force- the amount of labor available for producing goods and
services; all employed plus unemployed persons.
77
 …Inflation and Unemployment…cond.

…Unemployment…cond.
Two important labor force concepts:
ü unemployment rate- percentage of the labor force that is unemployed,
ü labor force participation rate- the fraction of the adult population that
“participates” in the labor force

Unemployment rate = , where labor force is all persons over

age 16 who are either working for paid job or actively
seeking paid employment.
Exercise: Based on the given information, compute labor force statistics

78
 …Inflation and Unemployment…cond.

…Unemployment…cond.
Use the above data to calculate
i. the labor force
ii. the number of people not in the labor force
iii. the labor force participation rate
iv. the unemployment rate

Answer:
Data: E = 138.9, U = 15.1, Adult Pop = 236.3
i) labor force
L = E +U = 138.9 +15.1 = 154.0
ii) not in labor force
NILF = POP – L = 236.3 – 154.0 = 82.3
iii) unemployment rate
U/L x 100% = (15.1/154.0) x 100% = 9.8%
iv) labor force participation rate
L/POP x 100% = (154.0/236.3) x 100% = 65.2%
79
 …Inflation and Unemployment…cond.

Exercise: Compute percentage changes in labor force statistics

Suppose
– population increases by 1%
– labor force increases by 3%
– number of unemployed persons increases by 2%

Required:
i) Compute the percentage changes in the labor force participation rate.
= Percentage change in (X/Y )  percentage change in X  percentage change in Y
= 3% -1% = 2%

ii) Compute the percentage change in the unemployment rate:

= Percentage change in (X/Y )  percentage change in X  percentage change in Y
= 2% -3% = -1%

80
 …Inflation and Unemployment…cond.
Types of unemployment
• Frictional unemployment - temporary and quickly wiped out through an automatic
process of market mechanism and adjustment (time taken to
match workers with job due to information or geographic
barriers),
• Structural unemployment – arises due to:
ü structural change in dynamic economy- say from agriculture to industry, from
labor intensive to technology intensive etc,
ü wage rigidity- due to minimum wage law, unions & collective
bargaining, efficiency wage( w/c is meant to promote
better nutrition & health, reduce employee turnover,
reduce adverse selection and moral hazards ), etc.
• Cyclic unemployment- is associated with short run fluctuation of the economy,
where workers become unemployed for some period when
their job evaporates due to recession and returns to job
when there is expansion in economic activities.
Note: High unemployment rate means underutilizations of resources, and hence
production of less goods and services(decreases the real GDP of an
economy, w/c in turn affect the wellbeing of citizens).
81
 …Inflation and Unemployment…cond.

Business Cycle and the Output Gap

• Inflation, growth, and unemployment are related through the business cycle

• The business cycle is the more or less regular pattern of expansion

(recovery) and contraction (recession) in economic activity around the path of
trend growth,

• At a cyclical peak, economic activity is high relative to trend; and at a cyclical

trough (depression), the low point in economic activity is reached.

Fig: Business Cycle

• Potential output level- is full employment level of output ,

• Actual output level – the output actually produced in an economy during a given period of time, 82
• Output gap- potential output minus actual output.
OKUN’S LAW- THE RELATION BETWEEN OUTPUT, UNEMPLOYMENT, AND INFLATION

u t  u t 1   0.4 ( g yt  3%)
Okun’s Law: The below figure shows the Relationship Between
Unemployment and GDP Growth/output

90

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OKUN’S LAW- THE RELATION BETWEEN OUTPUT, UNEMPLOYMENT, AND INFLATION..COND

Okun’s Law
ut  ut 1   0.4( g yt  3%)

 According to the equation above,

If g yt  3% , then ut  ut 1   0.4(  )  0
If g yt  3% , then ut  ut 1   0.4(  )  0
If g yt  3% , then ut  ut 1   0.4(0)  0

To maintain the unemployment rate constant, output growth

must be 3% per year. This growth rate of output is called the
normal growth rate.

91

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OKUN’S LAW- THE RELATION BETWEEN OUTPUT, UNEMPLOYMENT, AND INFLATION..COND

Okun’s Law
ut  ut 1   0.4( g yt  3%)
According to the equation above, output growth 1% above normal
leads only to a 0.4% reduction in unemployment, for two reasons:

1. Labor hoarding: firms prefer to keep workers

rather than lay them off when output decreases.

2. When employment increases, not all new jobs are

filled by the unemployed. A 0.6% increase in the
employment rate leads to only a 0.4% decrease in the
unemployment rate.

92

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OKUN’S LAW- THE RELATION BETWEEN OUTPUT, UNEMPLOYMENT, AND INFLATION..COND

Okun’s Law

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ut  ut 1   0.4( g yt  3%)

 Using letters rather than numbers:

ut  ut 1    ( g yt  g y )

Output growth above (below) normal leads to a decrease

(increase) in the unemployment rate. This is Okun’s law:

g yt  g y  ut  ut 1

g yt  g y  ut  ut 1
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OKUN’S LAW:

 more of an empirical “rule of thumb” than a relationship

grounded in theory.

 Okun’s Law suggests that a decline in output growth

between 2% and 3% is associated with a one percentage
point increase in the aggregate unemployment rate.

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 …Inflation and Unemployment…cond.

The Phillips curve

ü describes the empirical relationship between inflation and unemployment:

o the higher the rate of unemployment, the lower the rate of inflation; and vice-varsa,

o the curve suggests that less unemployment can always be attained by incurring more inflation ,

o inflation rate can always be reduced by incurring the costs of more unemployment.

o in other words the curve suggests there is a trade-off between inflation and unemployment.

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1. Gross Domestic Product (GDP) measures both total income and
total expenditure on the economy’s output of goods & services.
2. Nominal GDP values output at current prices;
real GDP values output at constant prices. Changes in output
affect both measures,
but changes in prices only affect nominal GDP.
3. GDP is the sum of consumption, investment, government
purchases, and net exports.
4. The overall level of prices can be measured by either
– the Consumer Price Index (CPI),
the price of a fixed basket of goods
purchased by the typical consumer, or
– the GDP deflator,
the ratio of nominal to real GDP
5. The unemployment rate is the fraction of the labor force that is not
employed. 89