# # Macroeconomics Chapter 2

CHAPTER TWO
NATIONAL INCOME ACCOUNTING
2.1 Approaches of Measuring GDP

2.2 Other Social Accounts (GNP, NNP, NI, PI and
DI)
2.3 Nominal versus Real GDP
2.4 GDP and Welfare
2.5 The GDP Deflator & the Consumer Price Index
2.6 The Business Cycle
2.7 Unemployment and Inflation Compiled by Tesfaye E.,;WU; department
11/24/2014 of economics 1
Concepts of national income accounting
 National Income accounting refers to a set of rules and
techniques that are used to measure the national income of a
country.
 National income is a measure of the value of goods and
services produced by the residents of an economy in a given
period of time, usually a year.
 National income accounting is a government bookkeeping
system that measures a country's economic activity—
offering insight into how an economy is performing.
Compiled by Tesfaye E.,;WU; department

Cont…..
• National Income Accounting (NIA) is an accounting
record of the level of economic activities of an
economy as a whole.
• It is a measure of an aggregate output, income and
expenditure in an economy.
National income in many countries is either
represented by Gross Domestic Product (GDP) or
Gross National Product (GNP).
National income accounting systems allow countries
to assess the current standard of living or the
distribution of income within a population, as well
as assess the effects of various economic policies.

Need of national income accounting
Indicates of economic growth:
 It indicates performance and the level of economic growth
in an economy. The data on national income and per capita
display the true picture of the health of an economy. It both
are increasing continuously. It surely reflects an increase in
economic welfare, otherwise not
Helps in policy formulation
 Statistical data on national income not only helps in making
economic analysis but also helps in policy formulation.
Moreover it into only helps in formulating fiscal policy,
monetary policy, foreign trade policy but also helps in
making modifications and amendments wherever necessary.

Cont….
 Helpful in making comparison:
 It helps us in comparing national income and per capital
income of our country with those of other countries. This may
leads us to make suitable changes in our plans and approach
to achieve rapid economic development of our country.
 Helpful to trade unions:
 National accounts throw light on distribution of factor income
which is very helpful to trade unions and other labour
organizations in making rational analysis of the remuneration
the labourers are getting.
 Distribution of income:
 National income accounting describes distribution of national
income in terms of factors like interest, rent, profit & wages.
 It also shows the relative significance of the factors of
production in the economy.
Cont….
 Helpful in economic planning:
National income accounting is helpful in economic
planning. The planning commission comes to know
about the resources available for economic planning.
 Structural changes in the economy:
NIA is helpful in providing knowledge of structural
changes in the economy. We are able to know that
decrease or increase in share of agriculture and industry
in national income. It helps to know the sectorial
contributions.
 Facilitate forecasting:
NIA is helpful in forecasting the effect of economic
policies on the level of productionCompiled
andbyemployment.
Tesfaye E.,;WU; department
Cont.….
 In sum up: National income accounting:
 Designed to measure the overall production performance of the
economy;
 show the long-run course that the economy has been following;
 provide basis for formulation & application of public policies.
 The best available indicator of economy’s wellbeing is

its total output of goods & services or aggregate output.
 Two basic social accounting measures of the total output of goods

& services are GDP & GNP.

National Income Accounting indicators
 GDP is the total monetary value of all final goods & services
produced within the territories of the economy in a given year.
 It is the monetary values of output produced using all the factors of
production located in the territory of a country whether owned by
foreigners or domestic citizens. It is territorial.
 GNP is the total monetary value of all final goods & services
produced by factors of production owned by citizens of the country
in a given year, regardless of were is produced. Output can be
produced either inside or outside the boundary of the country. It is
citizenship.
 Thus, GDP & GNP are related as follows:
GNP = GDP + Net Factor Income (NFI)
 NFI = Factor income earned by citizens (all resources) from abroad
minus factor income earned by foreign resources.

Cont.….
 GDP is more commonly taken as the basic
measure of a nation’s output as compared to
GNP. This is because:
 GDP is easier to measure, since data on net foreign
earnings are usually poor,
 GDP is better measure of the job-creating potential
of the economy than is GNP, and
 It makes international comparisons easier, as most
countries use GDP.

What is included & what is not?
What are included:
All the currently produced goods and services which has
market prices:
 Final goods and services with having market price
 Intermediate goods that have not yet been used in final
goods and services.
 Raw materials that have been produced, but not yet used in
the production of intermediate or final goods.

Cont…
1) What should be excluded:-

 NIAs ignore:
1. Transactions involving intermediate goods (in order to avoid
double counting).
2. Non-productive transactions: purely financial transactions (public
& private transfer payments, and buying & selling of securities) as
recipients make no contribution to current production in return.
3. Second-hand sales as such sales either do not reflect current production
or involve double counting. Sales of used goods not be included in order
to avoid double counting problems.
4. Exclusion of non-market products/Non-market activities: there are
various types of output produced, with have no estimated market values,
such as home activities, child care, etc.
5. Illegal goods: all the black market economic activities are not
included due to its difficulty of information.
6. Intermediate goods that are used to produce other final goods.
7. Non-domestic product: Sales of goods that were produced
outside our borders should be excluded from GDP
calculation. Compiled by Tesfaye E.,;WU; department
Method/approaches to measures GDP
There are three different methods to measure GDP.
These are:
1. The output approach
2. The expenditure approach and
3. The income approach.
 In the absence of any measurement errors, the three
approaches will deliver exactly the same result. Each
approach is simply constitutes a different way of
looking at the same thing.
 All three methods for measuring GDP give equal
results because the aggregate spending on goods
and services is the income to the firms. And every
final good or service produced is a part of aggregate
spending either through consumption or investment
by firms.
Cont…
 The GDP, which is the total value added of products, should

match the income received by the firms from the production of
those products. The flow of funds received by the firms is
distributed in wages, rent, profit, interest repayments etc.
 The goods and services produced are either consumed or used
as inventories. Consumed goods add to consumer spending, and
inventories are the firms' spending (investment on the
products). Thus, the aggregate spending is equal to the total
value of final goods and services.

Product/Output approach or Value Added
• In output approach, GDP can be measured either using
final values output or value added in each stage
of production.
 GDP is the sum of the market value of final goods &
services or the sum of the value added at each stage of
production.
Stages of Production Sales Value Value Added
(Birr) (Birr)
Firm A, sheep ranch 60 60

Firm B, Wool processor 100 40
Firm C, suit manufacturer 125 25
Firm D, clothing wholesaler 175 50
Firm E, clothing retailer(final values of 250 75
sheep ranch)
Total sales value 710
Total Value added 250
Cont….
The value added approach measures economic
activity by adding the market value of goods and
services produced. It excludes the value of any goods
and services used up in intermediate stages of
production.
The approach makes use of the concept of value-
added. The value added for any producer is the
difference between the value of output and the value
of inputs it purchased from other producers.
Value added is computed by taking the difference
between the value of gross output of all goods and
services produced in a given period and the value of
all intermediate inputs used in the production process
at each stage during the same period.
Cont…

Expenditure Approach
• All final goods & services produced in an
economy are purchased either by three
domestic sectors: households, government &
business firms; or by foreign nations.
GDP = C + I + G + NX
? ? ? ?
 Is all that is produced sold?
 Changes in Inventories!
 This approach includes expenditures on goods and services
to satisfy the needs of final buyers.
 The expenditure on intermediate goods and services; resale
of consumer and capital goods are excluded from being
calculated in GDP measure.
Cont…
 The national income accounts divide GDP into four broad

categories of spending:
 Consumption (C)
 Investment (I)
 Government purchases (G)
 Net exports (NX).
 Thus, letting Y stand for GDP,
 Y = C + I + G + NX.
 GDP is the sum of consumption, investment, government
purchases, and net exports. Each dollar of GDP falls into
one of these categories.
 This equation is an identity: an equation that must hold
because of the way the variables are defined.
 It is called the national income accounts
Compiled byidentity.
Tesfaye E.,;WU; department
Cont…
 Consumption consists of the goods and services

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

Cont…
Investment consists of goods bought for future use.

Investment is also divided into three subcategories:
1. Business fixed investment,
2. Residential fixed investment, and
3. Inventory investment.
Business fixed investment is the purchase of new
plant and equipment by firms.
Residential investment is the purchase of new
housing by households and landlords.
Inventory investment is the increase in firms’
inventories of goods (if inventories are falling,
inventory investment is negative).
Cont…
Government purchases are the goods and
services bought by federal, state, and local
governments.
This category includes such items as military
equipment, highways, and the services that
government workers provide.
It does not include transfer payments to
individuals, such as Social Security and welfare.
Because transfer payments reallocate existing
income and are not made in exchange for goods
and services, they are not part of GDP.
Cont…
 Net exports: takes into account trade with other countries.

 Net exports are the value of goods and services exported to
other countries minus the value of goods and services that
foreigners provide us.
 Net exports represent the net expenditure from abroad on our
goods and services, which provides income for domestic
producers.
 In contrast to the income approach, the expenditure approach
focuses on the uses of GDP across various expenditure
categories.
 The expenditure C , G and I consists of expenditure on
imported goods which are not part of Ethiopian GDP.
 Foreign countries also spend on our export, which is not part of
their output. Thus, X-M should be considered in oredr to get
the net spending by a nation. 11/24/2014 Compiled by Tesfaye E.,;WU; department
of economics 22
The Income Approach
 As the name suggests, the income approach calculates the GDP by

summing up the income earned by domestic factors of production
annually.
 GDP can also be determined by summing up incomes derived
from the production of total output.
 GDP is the sum of all incomes earned by all factors of
production which contribute to production plus 2 non-factor
payments.
 Therefore, GDP is the sum of the following items.
1. Compensation of employees (W, S): this is the income from

sales of labor services during a given year. It incorporates wages,
salaries, and fringe benefits such as employers provided
insurance and employers contribution to pension funds.
2. Rental incomes (R): is earned by those who supply the services
of land, mineral rights, and building for use by others.
3. Interest (I): includes interest payments individuals receive on
saving, certificate deposit and corporate bonds.
Cont…
4. Proprietor’s income (∏p): is net income of sole

proprietorships and partners.
5. Corporate profit (∏c): includes dividends,
undistributed profits, and corporate profits taxes.
6. Indirect business taxes (IBT): taxes imposed on sales
final products by business firms that increases the cost
of these firms and are therefore, reflected in the
market value of goods and services sold. Example:
sales tax, excise tax, business property tax, license fee.
7. Capital consumption allowance (D): depreciation of
capital assets.
 Then the gross domestic product/income (GDP) is defined
as:
GDP = (W+S) + R + I + ∏ + D + IBT, where
Compiled by Tesfaye∏ =∏
E.,;WU; p + ∏c
department
Other Social Accounts
The national income accounts include other measures of income that differ
slightly in definition from GDP.
To see how the alternative measures of income relate to one another, we start with
GDP and add or subtract various quantities. To obtain gross national product
(GNP), we add receipts of factor income (wages, profit, and rent) from the rest of
the world and subtract payments of factor income to the rest of the world:
GNP = GDP + Factor Payments From Abroad − Factor Payments to Abroad.
Whereas GDP measures the total income produced domestically, GNP measures
the total income earned by citizens of a nation.
For instance, if a Japanese resident owns an apartment building in Ethiopia, the
rental income he earns is part of Ethiopian GDP because it is earned in Ethiopia.
But because this rental income is a factor payment to abroad, it is not part of
Ethiopian GNP.
To obtain net national product (NNP): we subtract the depreciation of capital:-
the amount of the economy’s stock of plants, equipment, and residential
structures that wears out during the year.
NNP = GNP − Depreciation. Compiled by Tesfaye E.,;WU; department
Cont…
 In the national income accounts, depreciation is called the
consumption of fixed capital
 Because the depreciation of capital is a cost of producing
the output of the economy, subtracting depreciation shows
the net result of economic activity.
 The next adjustment in the national income accounts is for
indirect business taxes, such as sales taxes.
 These taxes, which make up about 10 percent of NNP,
place a wedge between the price that consumers pay for a
good and the price that firms receive.
 Because firms never receive this tax wedge, it is not part
of their income.
 Once we subtract indirect business taxes from NNP, we
obtain a measure called national income.
 National Income = NNP − IndirectCompiled
Business Taxes.
by Tesfaye E.,;WU; department
Cont….
 National income measures how much everyone in the economy
has earned.
 The national income accounts divide national income into five
components, depending on the way the income is earned. The
five categories, of national income paid in each category, are
 Compensation of employees: the wages and fringe benefits
earned by workers.
 Proprietors’ income: the income of non corporate businesses,
such as small farms, and law partnerships.
 Rental income: the income that landlords receive, including the
imputed rent that homeowners “pay’’ to themselves, less
expenses, such as depreciation.
 Corporate profits: the income of corporations after payments to
their workers and creditors.
 Net interest: the interest domestic businesses pay minus the
interest they receive, plus interest earned from
Compiled foreigners.
Cont….
A series of adjustments takes us from national

income to personal income, the amount of income
that households and non corporate businesses
receive.
Three of these adjustments are most important.
First, we reduce national income by the amount
that corporations earn but do not pay out, either
because the corporations are retaining earnings or
because they are paying taxes to the government.
This adjustment is made by subtracting corporate
profits (which equals the sum of corporate taxes,
dividends, and retained earnings) and adding back
dividends. Compiled by Tesfaye E.,;WU; department
Cont…
 Second, we increase national income by the net

amount the government pays out in transfer
payments.
 This adjustment equals government transfers to
individuals minus social insurance contributions paid
to the government.
 Third, we adjust national income to include the
interest that households earn rather than the interest
that businesses pay.
 This adjustment is made by adding personal interest
income and subtracting net interest. (The difference
between personal interest and net interest arises in
part from the interest on the government debt.)
 Thus, personal income is: Compiled by Tesfaye E.,;WU; department
Cont…
Personal Income = National Income
− Corporate Profits
− Social Insurance Contributions
− Net Interest
+ Dividends
+ Government Transfers to Individuals
+ Personal Interest Income.
 Following this, if we subtract personal tax payments and certain nontax
payments to the government (such as parking tickets), we obtain
disposable personal income:
 Disposable Personal Income = Personal Income – Personal Tax and
Nontax Payments.
 We are interested in disposable personal income because it is the amount
households and non corporate businesses have available to spend after
satisfying their tax obligations to the government. Disposable personal
income can be used either for Consumption or saving.
 PDI = C + S
Other Social Accounts (GNP, NNP, NI, PI and DI)
GDP + NFI
= GNP –D
= NNP – IBT
= NI + Net Transfer
payments
Received
– Social security
contributions
– C Taxes
– Undistributed C
= PI – PT
11/24/2014
of economics
= DI
31
Nominal versus Real GDP
 Nominal GDP(NGDP): it is the monetary /the
market value of all final goods & services
produced at particular time valued at current
prices.
 But productions of different years’ cannot be
compared using NGDP since the value of money
changes.
 Because GDP is a price times quantity figure
(PiQi), changes in either quantities or prices
affect the size of NGDP.
 But it is the quantity of goods & services
produced & distributed which affects the
standard of living, not the price.
Cont…
 To illustrate the difference between Nominal GDP and Real
GDP consider an economy producing only two goods: Teff
and Sugar.
 In this economy GDP is the sum of the values of all the Teff
produced and the values of all the sugar produced.
 That is:
 GDP = (Price of Teff X quantity of Teff produced per year) + (Price of
Sugar X quantity of Sugar produced per year).
 Apparently, GDP is a good way of measuring the average
dollar value of the goods produced in any year.
 Yet it is not a good way of measuring differences in the
average quantities of goods produced over time because
GDP can go up from year to year for two reasons: because
of price rises or because of quantity rises.

Cont…
 Thus, GDP computed by this method is not a good
measure of economic well being.
 This means, nominal GDP does not accurately
reflect how well the economy can satisfy the
demand of economic agents.
 If all prices doubles without any change in quantities
of goods and services produced, GDP would double.
 At this junction, it would be misleading to say that
the economy’s ability to satisfy demands has
doubled, since quantities of everything goods and
services produced remain unchanged.
 Economists call the values of goods and services
measured at current prices nominal GDP.
Cont….
 To compare GDPs of different periods (or to see changes in
economic performance) NGDP must be adjusted for price changes.
 In other words, real or constant-Birr GDP should be used.
 RGDP measures each year’s output in terms of the prices prevailed
in a selected base year.
 Real GDP, which is the value of all goods and services produced during
a year measured using a common set of prices. These prices are the
ones that prevailed in one year – called the base year
Year Quantity Price RGDP (in 2000

NGDP year)
1999 10 20,000 200,000 200,000
2000 12 20,000 240,000 240,000
2001 13 26,000 338,000 260,000
2002 13 30,000 390,000 260,000

Exercise
Year No.of Price of No. of car Price per unit
computer computer per produced of car
produced unit
1990 500000 6000&$ 1000000 12000$
2000 5000000 2000$ 1500000 20000$
A. Compute nominal GDP for the year 1990 and 2000

B. Calculate real GDP in 1990 and 2000, using 1990 as the base year
C. Calculate the percentage change in real GDP between 1990 and
2000 using 1990 as the base year.
D. Calculate real GDP in 1990 and 2000, using 2000 as the base
year.
E. Calculate the percentage change in real GDP between 1990 and
2000 using 2000 as the base year.
F. Explain why your answers to parts c and e are different. Do you
feel there is one that more accurately measures the true growth in
GDP? Which one, and why?
GDP and Welfare
 GDP has limitations in measuring the social wellbeing of
the people in a nation since:
 It excludes non-market transactions & thus
underestimates non-monetary economies.
 It does not include the underground economy (black
market) transactions.
 It ignores the quality of goods & services.
 It ignores cost of environmental damage, which could
decrease the quality of lives.
 It does not accounted for the satisfaction obtained
from recreational activities & other uses of leisure
time.
 It is based on estimations & thus may not accurately
reflect even the transactions it explicitly intends to
measure.

The GDP Deflator & the Consumer Price Index
 The GDP deflator, also called the implicit

price deflator of GDP, is defined as follows:
Nominal GDP
GDP Deflator   100
Real GDP
 NGDP = RGDP x GDP deflator (/100)
Measures the Measures the Measures the

current economy’s price of output
monetary
B output at
B
relative to its
B
value of the constant
economy’s prices price in the base
output year
 GDP deflator reflects what is happening to the
overall level of prices in the economy.
11/24/2014
of economics 38
Cont…
 Price Index: measures the combined price of a basket of
goods & services in a specific period relative to the
combined price of the same basket in a reference period.
 CPI is the most commonly used measure of the level of
prices (or cost of living).
 Just as GDP turns the quantities of many goods &
services into a single number, the CPI turns the prices of
many goods & services into a single index.
Cost of a Market Basket of Products at Current Prices

CPI   100
Cost of the Same Basket of Products at Base Year Prices
 NB: CPI = 100 for the selected base year.

The GDP Deflator & the Consumer Price Index
 CPI & GDP deflator differ in 3 main ways:
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. A change in the prices of goods
& services bought by firms or the government will show up in GDP
deflator but not in CPI.
2. CPI measures the cost of a given basket of goods & services,
which is the same from year to year. The basket of goods &
services included in GDP deflator differs from year to year, but
fixed in CPI. 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.
3. CPI directly includes prices of imports, whereas the GDP deflator
includes only prices of products produced domestically.
 Economists call a price index with a fixed basket of goods a
Laspeyres index and a price index with a changing basket a
Paasche index.
Cont….
 Neither of the two indices is clearly superior to

the other in measuring the cost of living.
 Moreover, the difference between them is
usually not large in practice.
 Thus, the CPI is also used to deflate nominal
GDP so as to arrive at the real GDP.
Nominal GDP NGDP

Real GDP    100
CPI/100 CPI

The Business Cycle, Unemployment and Inflation
 Business cycle: the term used to describe fluctuations in
aggregate production as measured by the ups & downs in
RGDP.
 Business cycle is the recurrent ups and downs in the levels
of economic activities that extend over a period of several
years.
 It is the non-regular pattern of expansion & contraction in
economic activity around the path of trend growth.
 The trend path of GDP is the path that GDP would take if
factors of production were fully employed.
 Over time, RGDP changes for 2 reasons:
1. More resources become available: rise in
population size, improved land, rise in stock of
knowledge. This allows the production of more
goods & services, resulting in a rising trend
level of output.
3.1 The Business Cycle
2. Second, factors are not fully employed all the time.

Thus, output can be increased by increasing capacity
utilization. Output is not always at its trend level, that
is, the level corresponding to full employment of the
factors of production. Rather output fluctuates around
Trend Level/
Output (Real GDP)
Peak
the trend level. Potential/
Con essio
Full-Emp’t
(Re
Output
trac n)
c
Actual
ti o n
(Rec sion
y)
Output
over
n
Expa
Trough
11/24/2014
Time
Compiled by Tesfaye E.,;WU; department of economics 43
Cont…
 Inflation, growth, and unemployment are related through

the business cycle.

Cont…
 Business cycle is thus characterized by peaks, trough, periods of

contraction and expansion.
 Peak: this refers to the full employment level of an economy. Here the
national output is at or very closer to the capacity. There is shortage of
labor, parties and materials. National income corresponds to the high
degree of factor utilizations. It is highly characterized by the presence of
inflation.
 Recession (Contraction): unemployment increases and less output is
produced than can in fact be produced with the existing resources and
technology. Prices also decline as unemployment increases.
 Trough: refers to the period when output and employment become at
nadir level. At this point there is massive unemployment and idle
productive capacities. Most businesses are likely to fail as there is small
demand for their products.
 Recovery (expansion): the employment of factors of production
increased, and that is a source of increased production.

Cont…
Business cycle movements are not regular in
timing or in size.
NB: is the trend growth rate constant: it varies
with changes in technical knowledge & the
growth of supplies of resources.
Output gap: deviations of output from trend (=
Potential Output – Actual Output).
 Output gap grows during recessions, & declines
(& even becomes negative) during expansions.
 A long expansion reduces unemp’t too much,
causes inflationary pressures & triggers policies
to fight inflation – such policies usually create
recessions.

Unemployment
 Unemployment occurs when someone is willing and able
to work but does not have a paid job or engaged in self-
employment.
 Unemployment, according to the OECD, is people above a
specified age not being in paid employment or self-
employment but currently available for work during the
reference period.
 A person is employed if he or she spent some of the
previous week working at a paid job, or engaged with self
employment.
 The labor force is defined as the sum of the employed and
unemployed, and the unemployment rate is defined as the
percentage of the labor force that is unemployed. That is,

Unemployment
Total population
Working-age Population Population outside Working-age
Labor Force (Currently Population Not

Active Population) Currently Active
Employed Unemployed
A person is said to be unemployed if he/ she
is in the working-age, without work,
available for work & actively seeking work.
Number of Unemployed
Unemp' t Rate   100
Number ofCompiled
labor force
Types of Unemployment:
• Different economists categorize unemployment in to
different groups. The most common form of unemployment
types are:
 Frictional unemployment: this is the most appearing form
of unemployment.
• At any point of time, some workers will be in the process
of voluntary switching jobs.
• Others will have jobs connection but will be temporally
laid off because of seasonality.
• Example: college graduates, agricultural workers during off
harvest time.
• It is resulting from people who have left jobs that didn’t
work out & are searching for new employment, or people
who are either entering or re-entering the LF to search for a
job.
• It result from natural & unavoidable occurrences in a
dynamic economy; and, often, one cannot be distinguished
from the other. Compiled by Tesfaye E.,;WU; department
Cont…
Structural unemployment: this is a type of

unemployment emanating from permanent
shift in the pattern of demand for goods and
services or from change in technology.
 Structurally unemployed people have skills
that are not in demand by employers due to
permanent change in technology of the
economy.
 It is resulting from permanent shifts in the pattern
of demand for goods & services or from changes
in technology such as automation.

Cont…
 Cyclical unemployment: results from the decline in real
GDP during period of economic down turn (recession) or in any
period when the economy fail to operate at its potential.
 It is resulting from declines in RGDP during
recessions, or whenever the economy fails to operate at
its potential.
 It is the result of imbalances b/n aggregate purchases &
aggregate production at full-emp’t.
 It receives the greatest attention since it is viewed as
controllable.
 Full emp’t does not mean zero unemp’t.
 It occurs when the actual rate of unemp’t is no more
than the natural rate of unemp’t.
Cont…
 The time, effort & transaction costs required to
find a new job guarantee that there will always be
some unemployed workers looking for jobs.
 Natural rate of unemp’t is the percentage of the
LF that is normally expected to be unemployed
for reasons other than cyclical fluctuations in
RGDP.
 In other words, natural rate of unemp’t is the sum
of frictional & structural unemp’ts expected over
a period (a year).
 An economy with actual unemp’t rate less than
the natural rate is said to be an overheated
economy.

Cont…
 An overheated economy can produce more than
the potential RGDP.
 But, most economists believe that this couldn’t
happen for long periods without consequences
that impair its future performance & ultimately
cause actual RGDP to decline to its potential
level.
 Cyclical Unemp’t (usually characterized by
layoffs - temporary suspensions of employment
without pay) tends to rise during recessions.
 This negative relationship between changes in
RGDP & changes in unemp’t rate is known as
Okun’s law.
3.2 Unemployment
Costs of Unemp’t:
 Unemp’t is of great concern because it has
costs. The main costs of unemp’t are:
1. Output is lost (GDP falls) because the
economy is not at full employment.
2. Distortional impact – unemp’t usually hits the
poor harder than the rich & this raises the
problem of raising income inequality.
3. The unemployed may have more leisure when
not working. But this benefit is more than
offset by costs to the society since:
 the value placed on that leisure is small as
much of it is unwanted leisure, and
 government loses income tax
Compiledrevenue.
Unemployment, GDP, and Okun’s Law
What relationship should we expect to find
between unemployment and real GDP?
Because employed workers help to produce
goods and services and unemployed
workers do not, increases in the
unemployment rate should be associated
with decreases in real GDP.
This negative relationship between
unemployment and GDP is called Okun’s
law, after Arthur Okun, the economist who
first studied it
Inflation
 Inflation is a rise in the general price level.
 The inflation rate measures how fast prices are rising.
 A dollar today doesn’t buy as much as it did 20 years ago
 With inflation, the purchasing power of a nation‘s
currency declines over time.
 Deflation is the opposite of inflation (it is a fall in the
general price level).
 Annual inflation rates are measured by percentage
change in a price index from one year to the other.
 Percentage change in CPI is the commonly used
measure of inflation, followed by percentage change in
GDP deflator.
CPI t  CPI t 1
Inflation Rate at Period t   100%
CPI t 1
Cont…
Inflation rate= (154.8-146)/146=0.06027

=6%
 Demand-pull inflation: Excess of total demand contributes to
the rise in general prices level. Firms and business sector
cannot, at least in the short run, respond to these excess demand
by expanding real output for the obvious reason that all factors
of productions are already at full employment. As a result, the
excess demand bids up the price of the fixed output, causing
demand-pull inflation.
 Cost push inflation: is the inflation emanating from the supply
side or cost side of the market. Unions developed to a
considerable degree of strength and have control over the wage
rates. They obtain increased wage. On the other side cost of
productive factors imported may also rise. As a result of an
increased cost of production large corporation pushes the
increased cost of production on to consumer by raising the
prices of their production. Compiled by Tesfaye E.,;WU; department
Cont...
 Structural inflation: is due to change in the structure of

total demand. This is due to the market power of big
business and unions. Prices and wages tend to be flexible
up ward but inflexible downward.

Cont….
The Philips Curve
The Phillips curve describes an empirical
relationship b/n inflation & unemp’t.
The curve suggests a trade-off between
inflation & unemp’t.
The Phillips Curve
Inflation Rate
0
Unemployment Rate
This trade-off should always be taken into

account when governments try to increase
output & emp’t or reduce inflation. 11/24/2014
of economics 59
Cont…
This trade-off between unemp’t & inflation
holds in the short run. (However, there are
disagreements among economists.)
In the long run, there is no trade-off worth
speaking about b/n inflation & unemp’t.
In the long run, unemp’t rate is independent
of inflation rate – the long run Philips Curve is
vertical at the natural rate of unemp’t.


# # Macroeconomics Chapter 2

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# # Macroeconomics Chapter 2

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CHAPTER TWO

NATIONAL INCOME ACCOUNTING

2.1 Approaches of Measuring GDP

Compiled by Tesfaye E.,;WU; department

Compiled by Tesfaye E.,;WU; department

Compiled by Tesfaye E.,;WU; department

 The best available indicator of economy’s wellbeing is

 Two basic social accounting measures of the total output of goods

Compiled by Tesfaye E.,;WU; department

Compiled by Tesfaye E.,;WU; department

Compiled by Tesfaye E.,;WU; department

Compiled by Tesfaye E.,;WU; department

1) What should be excluded:-

 The GDP, which is the total value added of products, should

Compiled by Tesfaye E.,;WU; department

Firm A, sheep ranch 60 60

Compiled by Tesfaye E.,;WU; department

 The national income accounts divide GDP into four broad

 Consumption consists of the goods and services

Compiled by Tesfaye E.,;WU; department

Investment consists of goods bought for future use.

 Net exports: takes into account trade with other countries.

 As the name suggests, the income approach calculates the GDP by

1. Compensation of employees (W, S): this is the income from

4. Proprietor’s income (∏p): is net income of sole

A series of adjustments takes us from national

 Second, we increase national income by the net

Compiled by Tesfaye E.,;WU; department

Year Quantity Price RGDP (in 2000

Compiled by Tesfaye E.,;WU; department

A. Compute nominal GDP for the year 1990 and 2000

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 The GDP deflator, also called the implicit

Measures the Measures the Measures the

Cost of a Market Basket of Products at Current Prices

Compiled by Tesfaye E.,;WU; department

 Neither of the two indices is clearly superior to

Nominal GDP NGDP

Compiled by Tesfaye E.,;WU; department

2. Second, factors are not fully employed all the time.

 Inflation, growth, and unemployment are related through

Compiled by Tesfaye E.,;WU; department

 Business cycle is thus characterized by peaks, trough, periods of

Compiled by Tesfaye E.,;WU; department

Compiled by Tesfaye E.,;WU; department

Compiled by Tesfaye E.,;WU; department

Working-age Population Population outside Working-age

Labor Force (Currently Population Not

Structural unemployment: this is a type of

Compiled by Tesfaye E.,;WU; department

Compiled by Tesfaye E.,;WU; department

Inflation rate= (154.8-146)/146=0.06027

 Structural inflation: is due to change in the structure of

Compiled by Tesfaye E.,;WU; department

This trade-off should always be taken into

Compiled by Tesfaye E.,;WU; department

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