Chapter 2 Macro

Chapter 2
National Income Accounting

2.1. The concepts of National Income
Accounting
National Income Accounting (NIA) is an accounting record of
the level of economic activities of an economy. It is a measure
of an aggregate output, income and expenditure in an
economy.
Why do we need to study NIA?
 It enables us to measure the level of total output in a given
period of time, and to explain the
causes for such level of performance.
 It enables us to observe the long run trend of the economy.
 It provides information to formulate policies and design plans.
2.2. The concepts of GDP and GNP
GDP: is the total value of currently produced final goods and services
that are produced within a country‘s boundary during a given period
of time, usually one year.
• It measures the current production only.
• It takes in to account final goods and services only
• It measures the values of final goods and services produced within
the boundary/territory of a country irrespective of who owns that
output.
• take the market values of goods and services
Where: Pi = series of prices of outputs produced in different sectors of

an economy in certain period
Qi = the quantity of various final goods and services produced in an
economy
Molla Dessie,CoBE,Economics
01/03/2023 3
Department,DMU
GNP: is the total value of final goods and services currently produced
by domestically owned factors of production in a given period of
time, usually one year, irrespective of their geographical locations.
GDP and GNP are related as follows:
• GNP=GDP + NFI
NFI denotes Net Factor Income received from abroad which is equal
to factor income received from abroad by a country‘s citizens
(FIRAC) less(minus) factor income paid for foreigners to
abroad(FIPF). Thus, NFI could be negative, positive or zero
depending on the amount of factor income received by the two
parties.
NFI=FIRAC-FIPF
 If NFI >0, then GNP > GDP
 If NFI<0, then GNP < GDP
 If NFI =0, then GNP =GDP
01/03/2023 4
Department,DMU
2.3. Approaches of measuring national income (GDP/GNP)
1. Product Approach(Value Added Method) : GDP is
calculated by adding the market value of goods and
services currently produced by each sector of the
economy. In this case, GDP includes only the values
of final goods and services in order to avoid double
counting.
There are two possible ways of avoiding double
counting.
• Taking only the value of final goods and services
• Taking the sum of the valued added by all firms at
each stage of production
01/03/2023 5
Department,DMU
6
01/03/2023 7
Department,DMU
2. Expenditure Approach: GDP can be estimated by summing up personal
consumption of households (C), gross private domestic investment (I),
government purchases of goods and services (G) and net exports (NE).
A. Personal consumption expenditure are expenditures by households on
durable consumer goods (automobiles, refrigerators, video recorders,
etc), non-durable consumer goods (clothes, shoes, pens, etc) and
services.
B. Gross private domestic investment is the sum of all spending of firms on
plants equipment, and inventories, and the spending of households on
new houses. Investment is broken down into three categories:
I. residential investment (the spending of households on the construction of
new houses),
II. business fixed investment (the spending of firms on buildings and
equipment for business use), and
III. inventory investment [the change in inventories(a complete list of items
such as goods in stock or the contents of a building or A quantity of
goods in stock including materials and finished product) ) of firms].
8
C. Government purchases of goods and services include all
government spending on finished products and direct
purchases of resources less government transfer payments
because transfer payments do not reflect current production
although they are part of government expenditure.
D. Net exports refer to total value of exports less total value of
imports.
9
01/03/2023 10
Department,DMU
3. Income approach: GDP is calculated by adding all the incomes
accruing to all factors of production used in producing the national
output and some other claims on the value of output
(depreciation and indirect business tax) less subsidies and transfer
payments.
NB. transfer payments are excluded from national income
 Transfer payments are payments which are made to the recipients
who have not contributed to the production of current goods and
services in exchange for these payments
 They are mere redistribution of income from taxpayers to the
recipients of transfer payments.
 They may take the form of old age pension, unemployment
benefit, subsidies, etc.
So GDP = Compensation of employees (wages & salaries ) + Rental
income + Interest income + Profits (proprietors‘ profit plus
corporate profit) + Indirect business taxes + Depreciation –
Subsidies - Transfer payments
11
01/03/2023 12
Department,DMU
01/03/2023 13
Department,DMU
Limitation of GDP measurement
 Definition of a nation: while calculating national income, nation does not
mean only the political or geographical boundaries of a country for
calculating the value of final goods and services produced in the country. It
includes income earned by the nationals abroad.
 Stages of economic activities: it is also difficult to determine the stages of
economic activity calculate the national income. The stage of economic
activity may be decided by the objective of NI calculation. If the objective is:
 To measure economic progress, then the production stage can be considered.
 To measure the welfare of the people, then the consumption stage should be
taken into consideration.
 Transfer payments: this also creates a great difficulty in calculating the
national income. It has generally been agreed that the best way is to consider
only the disposal income of the individuals of groups.
 Underground economy: no imputation is made for the value of goods and
services sold in the illegal market. The underground economy is the part of
the economy that people hide from the government either because they
wish to evade taxation or because the activity is illegal. The parallel exchange
rate market is one example.
14
Cont…
 Inadequate data: in all most all the countries, difficulty has been faced in
the calculation of national income due to lack of adequate data.
Sometimes, the data are not reliable.
 Non-monetized sector: this difficulty is special to developing countries
where a substantial portion of the total produce is not brought to the
market for sale. It is either retained for self-consumption or exchanged for
other goods and services.
 Valuation of depreciation: the value of depreciation is deducted from the
gross national product to get net national product. But the valuation of
such depreciation is full of difficulties
 Changes in price levels: since the national income is in terms of money
whose value itself keeps on changing, it is difficult to make a stable
calculation which is assessed in terms of prices of the base year.
 No focus on quality: it is difficult to account correctly for improvements in
the quality of goods. This has been the case for computers, whose quality
has improved dramatically while their price has fallen sharply. It also
applies to other goods such as cars whose quality changes over time.
15
 Demarcation of activities: no clear-cut demarcation between productive
and non-productive activities. For instance, production for self-consumption,
services rendered without remuneration, services of an artist, etc.
 Adoption problem: under-developed countries adopt the pattern suggested
by the U.N.O., which may be quite suitable for developed countries but
difficult to follow for an under-developed country.
 Barter system: In developing countries, even today a good part of exchange
is performed through barter systems. It is very difficult to estimate the
money value of this type of transaction.
 Double counting: difficult to distinguish between intermediate goods and
final goods. Therefore, sometimes the value of intermediate goods enters
into our calculation of national income.
 Non-maintenance of accounts: In developing countries small
unincorporated enterprises and self-employed persons do not maintain their
accounts properly. Thus it is difficult to get accurate information about their
contribution to national income.
01/03/2023 16
Department,DMU
2.4.Other Income Accounts
NDPMP = GDPMP – Depreciation
NNP=Gross National product – Capital consumption allowance=GNP-D
 Net national product is a more accurate measure of economy‘s annual output than
gross national product(fails to take into account capital consumption allowance
NNPFC or NI = NNPMP – Indirect taxes.
NI = Net National Product – Indirect Business Tax=NNP-IBT
 National income is the income earned by economic resource (input) suppliers for their
contributions of land, labor, capital and entrepreneurial ability, which are involved in
the given year‘s production activity.
 Indirect business tax, which is collected by the government, does not reflect the
productive contributions of economic resources because government contributes
nothing directly to the production in return to the indirect business tax and so
subtracted.
PI= NI – [social security contribution + corporate income tax + retained corporate profit]
+ [Public transfer payments (e.g. Subsidy) + net interest on government bond]
 PI refers to income earned by persons or households. Persons in the economy may not
earn all the income earned as national income.
DI = PI – Personal taxes
 DI = C + S where, C = personal consumption expenditure, S = Personal savings
17
2.5. Nominal versus Real GDP
Nominal GDP is the value of all final goods and services produced in a given year when
valued at the prices of that year.
where, P is the general price level and Q is the quantity of final goods and services
produced.
 changes in price leads to change in GDP.
 GDP is not adjusted for inflation.
Real GDP is the value of final goods and services produced in a given year when
valued at the prices of a reference base year.
 GDP is adjusted for inflation.
Significance of the Distinction
1 Real GDP truly reflects the performance and level of economic growth in an
economy, whereas Nominal GDP does not. Nominal GDP is affected by two
factors:Change in physical output, and Change in prices. In contrast, real GDP
is affected by only change in physical output->leads to a rise standard of living.
2 Real GDP is a better tool for making a year-to-year comparison of changes in the
physical output of goods and services. A sustained rise in real GDP reflects the
economic growth of the country, whereas a continuous fall in real GDP is an
indicator of recession, and depression.
3 Real GDP is often used in making international comparisons of economic
18
performance across countries.
01/03/2023 19
Department,DMU
01/03/2023 20
Department,DMU
01/03/2023 21
Department,DMU
22
23
24
2.6. The Business Cycle
Refers to the recurrent ups and downs (fluctuations) in the level of economic
activity
ups and downs in the level of total output and employment through time
wave-like fluctuations in economic activity reflected in basic economic
variables like employment, income, output and price level.
One business cycle includes the point from one peak to the next peak or
from one trough to the next.
A business cycle is a short-term fluctuation in economic activities.
The trend path of GDP is the path GDP would take if factors of production
were fully employed.
Periodicity between the cycles need not be same or similar(Business
cycles may vary in duration and intensity).
sequence of changes in a business cycle recur frequently and in a fairly
similar pattern (boom-> recession->depression->recovery pattern is always
the same).
Business cycles usually last for a period of 2 to 10 years.
25
There are four phases of business cycle
1. Boom or peak
Highest level of output & Period of prosperity
Period of maximum output expansion and very low level of unemployment
point which marks the end of economic expansion and the beginning of
recession
the economy‘s output is growing faster than its long-term (potential) trend
and is therefore unsustainable.
characterized by rising demand, rising prices, rising investment, rising
employment, rising incomes, rising purchasing power and so on.
investors, therefore, voluntarily undertake risks and go in for investment,
which further fuels boom conditions through the working of the multiplier
effect.
over-optimism in business psychology, and thus the economy can get over-
heated.
Maxim of recovery or expansion.
01/03/2023 26
Department,DMU
2. Recession/contraction:
the level of economic performance declines
output, national income and employment
declines
over-optimism in business psychology->the
economy can get over-heated->monetary
authorities, the financial institutions and
business itself may become cautious->cuts in
investment->cuts in employment, a fall in
incomes, and declines in purchasing power
and demand->Prices fall->economy
pessimism(recession or contraction).
01/03/2023 27
Department,DMU
3. Trough or Depression
Ineffective measures for recession-> business confidence to be lowest->
Investment, employment, output, income, and prices reach bottom-> economic
depression.
Lowest point in business cycle or the economy reached at low point
Severe form of Recession/contraction
end of a recession and the beginning of economic recovery/expansion.
unemployment rate is too high but total output reaches to low
4. Recovery/Expansion:
the economy starts to grow and there is an option of economic activity
between a trough and a peak.
total output starts to raise and unemployment starts to decline
28
2.7. Macroeconomic Problems
1. Unemployment
• Is a situation in which group of people who are in a specified
age (labor force), who are without a job but are actively
searching for a job.
• For a person to be categorized as unemployed, two conditions
must be fulfilled: the person is without a job and able to
work vs the person wants to have a job and is willing to
work at the current market wage rate.
 people who have other means of living, like property
incomes, and thus do not desire to have a job cannot be
called unemployed, but ‘voluntary unemployed .
• In the Ethiopia context, the specified age is between 14 and
60 which are normally named as productive population. Labor
force = Employed + Unemployed
29
01/03/2023 30
Department,DMU
Types of Unemployment
Commonly ,there are three types of unemployment
1. Frictional unemployment
refers to brief period of unemployment experienced by people due to the following reasons:
Seasonality of work . E.g. Construction workers
Entrance to the labor force. E.g. graduate students
people are thrown out of work in one location and are unwilling or unable to move to a
similar work in another area. E.g. Moving big industrial units and polluting industries
large cities to distant area.
Voluntary switching of job
Re-entering to the labor force due to changed social or family situations.
2.Structural Unemployment
unemployment which arises due to change in the pattern of demand, leading to changes in
the structure of production in the economy or
unemployment resulting from mismatch between skills and locations of job seekers and
location of vacancies. E.g. An agricultural graduate looking for a job at ―Piassa.
This can be caused by
Permanent shifts of demand for goods and services .
Technological change.
E.g. a change of energy use from coal to electric power.
an increased use of synthetic rubber than natural rubber.
31
3.Cyclical Unemployment
unemployment is associated with ‘trade cycles’ or ‘business

cycles’ or cyclical fluctuations in economic activity.
caused by slackness in business conditions.
During depressions, investment activities get discouraged.
Contractions in business activities renders large numbers of
workers unemployed.
Unemployment generated due to the absence of jobs and
vacancies
Happens due to deficiency in demand for goods and services
when the economy is in recession
Frictional and structural unemployment are known as natural
level of unemployment, because they are unavoidable.
32
Additional Terms
Underemployment: a situation in which people are engaged in jobs
but these jobs do not measure up to their capabilities, efficiency
and qualifications.
Involuntary Unemployment: a situation in which the workers are
willing to work under any conditions and at any wage rate but they
fail to get employment. In some parts of the world, the economy
fails to provide employment opportunities to the work force.
Voluntary Unemployment: When the economy offers
employment opportunities to the workers, but they themselves are
not willing to take up jobs because employment conditions, such as
wage rate, location, promotional avenues, physical environment,
attitude of the employer, etc., do not suit them.
Disguised Unemployment: When more workers are engaged in a
type of work than actually are required to do that work
01/03/2023 33
Department,DMU
Measuring Unemployment
Measured by unemployment rate, UR = TU/LF
TU = FU + SU + CU
NU=FU+SU or TU-CU
NUR = (FU + SU)/LF, NU/LF
where:
TU-total unemployment
FU- frictional unemployment
SU-structural unemployment
CU-cyclical unemployment
LF-labor force
NUR-natural unemployment rate
NB. Full employment doesn’t mean zero employment, rather UR ≤5%
Economic cost of unemployment is the amount of output that could
have been produced had the unemployed people been employed
01/03/2023 34
Department,DMU
2. Inflation
Is sustainable or continuous increase in general price level of
goods and services.
can be anticipated or unanticipated
A small rise in prices or an irregular price rise cannot be called
inflation.
During inflation, all costs and prices do not rise together and in
the same proportion. It is an increase in the general level of
prices measured by a price index, which is an average of
consumer or producer prices.
can also be measured using GDP deflator
35
Measuring Inflation
The GDP Deflator: measures the price of all goods and services
produced.
The calculation of real GDP gives us a useful measure of inflation
known as the GDP deflator. The GDP deflator is the ratio of
nominal GDP in a given year to real GDP of that year. It
reflects what‘s happening to the overall level of prices in the
economy.
36
Weaknesses of the GDP Deflator
It understates increases in the cost of living.
The GDP Deflator is based on the current basket of
goods and services, with the basket changing
over time (e.g. it does record that people
substitute between goods and services when
their prices change). What it does not capture is
that in substituting from a more expensive good
to others, that welfare may be lost because of
an overall increase in the cost of living.
01/03/2023 37
Department,DMU
The Consumer Price Index: measures the cost of a market basket of consumer
goods and services
• Is an indicator that measures the average change in prices paid by consumers
for a representative basket of goods and services. It compares the current and
base year cost of a basket of goods of fixed composition.
• a measure of the cost of a basket of goods and services expressed as a
percentage of basket's cost in a base year.
Example 1: if the basket costs $6,000 in the base year and $9,000 in 1975, the
1975 price index is 150. Prices have gone up 50 percent. The price index for the
base year is always 100.
Example 2: Calculating a Price Index
In 1980, Joe, in a typical week, bought ten bottles of wine (at $4 each) and
twenty pizzas (at $6 each). In 1985, wine cost $6 and pizza cost $8. What is
Joe's 1985 price index, using 1980 as the base year?
SOLUTION 137.5. The 1980 basket cost $160 in 1980 ($4 × 10 + $6 × 20) and
would have cost $220 in 1985 ($6 × 10 + $8 × 20). $220/$160 times 100 equals
137.5. 38
Price indexes often do not accurately measure the change in prices, because of two
major problems:
1. The CPI does no take into account quality improvements. Say firms add more features
to a good and charge the old price. In fact the price per feature has fallen, but this is
not reflected in the CPI. The CPI doesn’t distinguish between a price increase caused
by the same good being sold at a higher price, or a good with more features sold at a
higher price to reflect the cost of the new features.
2. The major price indexes (such as the CPI) ignore changes in consumption patterns.
Due to the law of demand, consumers buy less of those goods whose prices have
gone up more. In this way, consumers partially offset some of the impact of higher
prices on their cost of living. Because the CPI ignores this, it overstates the increase
in the cost of living. This problem is called "the index number problem.
3. The CPI does not take into account substitution effects arising from price increases.
Say the price of beef goes up, then people switch to buying more lamb or chicken, so
the cost of living does not increase by as much as the initial price increase.
4. The CPI does not measure all prices in all shops and is only calculated using samples
of prices from various locations from various shops. The samples do not include
prices of goods sold in discount shops, which causes the CPI to overstate increases in
the cost of living
01/03/2023 39
Department,DMU
The CPI versus the GDP Deflator
There are three key differences between the two measures.
1) GDP deflator measures the prices of all goods and services
produced, whereas the CPI measures the prices of only the
goods and services bought by consumers. Thus, an increase
in the price of goods bought by firms or the government will
show up in the GDP deflator but not in the CPI.
2) GDP deflator includes only those goods produced
domestically. Imported goods are not part of GDP and do
not show up in the GDP deflator.
3) The CPI assigns fixed weights to the prices of different
goods, whereas the GDP deflator assigns changing weights.
In other words, the CPI is computed using a fixed basket of
goods, whereas the GDP deflator allows the basket of goods
to change over time as the composition of GDP changes.
40
Example: Calculating the consumers price index and the inflation rate. Assume a simple
economy in which a typical consumer buys only two goods-wheat and edible oil. The
consumer buys 50 kg of wheat and 10 liters of oil per year and assume that the
prices of these basket of goods in three different years are the following
Solution:
Step 1: Compute the cost of the basket of goods in each year.
Year Price of a kilo of wheat Price of a liter of oil
2000 E.C. (Birr 2 per kg × 50 kg ) + (Birr 10 per liter × 10 liter) = birr 200
Step 2: Choose one year as a base year (2000) and compute the consumer price index
in each year 41
01/03/2023 42
Department,DMU
Causes of inflation
Generally, there are two causes of inflation
1. Demand – pull inflation
resulting from an increase in demand for goods and services while the economy
is producing at or close to full employment
Aggregate demand grows greater than economy's productive capacity at full
employment
Situation of too much money chases too few goods.
The various causes for demand-pull inflation include:

A. Government expenditure increment->price rise
B. Money supply increment-> purchasing power rises-> prices rises.
C. Investment increment-> large demand for goods and services-> price rises,
D. wages increment ->general price level rises.
E. Black money(money spent on non-essential goods and services)->prices rises
F. Deficit financing->money supply rises->price rises
G. Credit Expansion->people buy more good->demand for goods increases -
>increase in the prices of goods.
01/03/2023 43
Department,DMU
2. Cost -push inflation
Arises due to a continuous decline in aggregate supply of goods and
services
Due to bad weather condition, an increase in wage and price of other
inputs or
Resulting from rising costs of production and slack resource utilization
shortage of raw materials, power breakdowns, strikes and lockouts, bad
weather conditions, increase in input prices->decreased supply of
goods in comparison to their demand->price rise.
hoarding, both by firms and households->supply of goods and services in
the economy->rise in price level.
Remarks:
Demand-pull and cost-push inflation go together(Intermingle, and not
possible to separate them) in an economy. In both situations, two
common features exist:
• rise in the prices of factor inputs, and
• rise in the prices of final goods.
44
Effects of inflation
A. Favorable Effects
1. production :prices are rising->profit expectations rise->investment -
>greater production
2. Capital Formation : Rising price-> profit expectations rise-> reinvested -
>higher capital formation
3. Employment: Rising prices-> increased investment->adding profits-
>reinvestment->more labor and other resources->labor employment
increases
4. Economic Development: Rising prices->raise profit expectations-
>investment->increase production and employment->increase in the
growth rate of national income and raise the tempo of economic
development. .
5. Self-Liquidating: Since inflation is caused by an excess of demand over
supply, the supply will increase after some time and become equal to
demand. The prices would thus fall due to increased supply, and inflation
would end. Thus, inflation can be self-liquidating.
45
B.Adverse Effects
1. Income Effect: rising prices -> reduce fixed wages purchasing power
(welfare) ->loss in real income.
2. Saving Effect: prices rise-> reduce money purchasing power->more
money buy the same amount of goods and services->reduces savings out
of a given level of income.
3. Redistribution Effect: price rise->profits keep on increasing-> income
of the industrial and business classes increases relative to the income of
working classes/ wealth users ->redistribution of income in favor of the
rich capitalists and business people->the gap between the rich and the
poor increases.
4. Price-Wage Spiral: price rise->laborers demand higher wages->rise in
prices->rises in wages. This creates a vicious circle of wage and price rises.
5. Economic Planning: price rise->actual cost of inputs to be used for
achieving production targets becomes higher->more financial resources
are needed. But inflation->reduce saving and more difficult for
governments to impose new taxes to collect more revenue->plan targets
are either curtailed or most of them remain beyond reach->upsetting the
whole planning process. 46
6. Balance of Payments: high prices->foreigners buy less of
our high priced goods & our people will buy more of the
relatively cheaper foreign goods ->export falls & import
increases->more payments than recipes->BOP deficit.
7. Raise the nominal interest rate and the opportunity cost
of holding money, I= r+П.
hold less money -> more trip to bank ->shoe-leather cost
8. Reduces investment by increasing nominal interest rate
and creating uncertainty about macroeconomic policies
9. Menu cost: cost of Printing and distributing new catalogue
10. Rising prices encourage speculation and hoarding,
profiteering, corruption, strikes, social unrest, and many
more problems.
47
3. Deficits
A budget shows the details of the planned expenditures of the government program and the expected
revenues from tax and non-tax sources for a year.
The government receives revenue from taxes and uses it to pay for government purchases.
Any excess of tax revenue over government spending is called public saving, which can be either
positive (a budget surplus) or negative (a budget deficit).
A. Budget deficit
• Is when a government spends more than it collects in taxes
• pumping more money into the economic system than it is pumping out. When it puts in more
money into the economy, the level of economic activity expands.
• Government finances by borrowing from internal, external borrowing and printing of new currency
Deficit is good but not beyond optimum.
The national income accounts identity shows that net capital outflow always equals the trade balance.
Mathematically, Net Capital Outflow = Trade Balance, S − I = NX
Balance of Trade (NX) = Merchandize Exports – Merchandize Imports
B. Trade deficit (current account deficit )
• Is when the balance between S − I and NX is negative,
• In this case, we are net borrowers in world financial markets, and we are importing more goods than
we are exporting
Deficit is good if the importer country is importing capital/machines/. Because it helps to produce
more in the future
Deficit is bad if the importer country is importing consumer goods. Because it decreases demand for
domestic consumer good 48
01/03/2023 49
Department,DMU
2.8. GDP and Welfare

Chapter 2 Macro

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 2 Macro

Uploaded by

Copyright:

Available Formats

Chapter 2

National Income Accounting

Where: Pi = series of prices of outputs produced in different sectors of

unemployment is associated with ‘trade cycles’ or ‘business

can also be measured using GDP deflator

The various causes for demand-pull inflation include:

You might also like