Chapter 2: National Income Accounting

Introduction
National income accounting is an official measurement of the flow of income and final (or
finished) product in an economy for a given period of time. It measures aggregate economic
activity or total output (income) of an economy for given period of time and it can be represented
by Gross Domestic Product (GDP) or Gross National Product (GNP) in an economy.
1. Circular Flow of Income
We introduce a concept, namely circular flow of income in a two sector economy before we start
studying the various concepts of National Income. In the two sector economy, there are two
sectors namely, Households (i.e. factor market) and Businesses or firms (i.e. product market).
The households provide their human power to firms in the form of labour and they earn wages
(i.e. their INCOME), which can be spent (i.e. EXPENDITURE) to buy the goods and services
produced by firms in the country. In this simple economy, the goods and services of a country
flow from firms (Businesses) to households. Therefore, Income and expenditure are equal in
this simple economy.

Circular Flow of Income in Two Sector Economy

Income
Factor input (Factor Market)

Household Firms
Product Market
Goods and service
Expenditure
Figure 1. Circular flow of income and product
The flow of income and products in the economy has been shown in figure 1.1, which shows
circular flow of income and products.
Have you noticed in the figure that what is the arrow in circular flow represented? The upper two
arrows represent factor market. It is a market in which factor input exchange for income.
Households by providing input such as labour and capital to firms, they earn income. So it
measures the flow of income from firms to households in return to factor input. The bottom
arrows on the other hand represent product market. It is a market in which households spends
their income earned in the factor market on goods and services produced by firms.
GDP measures such flow of income and output in an economy. Depending upon the
route we follow to measure the flow of income and output, it is possible to identify three
different approaches used to measure GDP. These are INCOME APPROACH,
EXPENDITURE APPROACH and VALUE ADDED APPROACH. The three methods result
in the same value of GDP since the expenditure of one agent becomes the income for others.

2. Basic Principles behind the Accounts

Aggregation: Account should aggregate economic variables in such a way that should be useful
to conduct economic analysis. For example, Sectors of expenditures should be aggregated by
who does the spending, i.e. into expenditures by consumers, businesses, governments, and
foreigners. (Each set of spending has different motivation and thus to a different set of other
economic variables).
Account should measure current flow of goods and services or it goods should add value to the
current income. For example, if someone buys a second hand car (existing asset) will enter the
accounts only if the purchase price exceeds the sale price of the previous owner. If the purchase
price of the present buyer and selling price of the old owner is same, then the car is not adding
any value to the current flow of income. Thus, transaction of the past product will not be
included (not counted) in national accounts.
The concepts of Gross Domestic Product (GDP) & Gross National Product (GNP):
Gross Domestic Product (GDP) and Gross National Product (GNP) are the two important
components in National Income Accounting.
GDP: GDP is the market value (money) of all final goods and services produced within the
domestic territory of a country during a specified period of time (for example, a year). GDP
include the goods and services produced by domestic factories of the country and foreign-owned
factories operated in the country. However, the GDP does not include value of goods and
services produced by the people of a country who are working abroad.
In GDP calculation, we add many different kinds of products into a single measure of the value
of economic activity.

Note: Goods and services produced by Ethiopians, who work in foreign countries (abroad) are
 not part of GDP of Ethiopia, whereas goods and services produced by any foreigners working in
Ethiopia are part of GDP of Ethiopia.

Case 1: John is an Ethiopian, who works in Microsoft Corporation the USA and earn $ 36000
per annum and remit (send) his income to Ethiopia. This is not included in the GDP of Ethiopia.

Case 2: Sarah is a British lady, who works in Ethiopia and earns 120,000 Birr annually and send
this cash to Britain. The income send by Sarah cannot be included in the GDP of Britain.

3. Gross National product (GNP): GNP is the market value of all goods and services produced by
the people of a country in a given period regardless the place of the production. The goods and
services produced by Ethiopians, who work in abroad are included in GNP of Ethiopia, whereas
the goods and services produced by foreigners who works in Ethiopia are excludes from the
GNP of Ethiopia.
Note (1): Only final goods and services produced by a country should be included in the
calculation of GDP and GNP. This helps us to avoid problems of double counting (counting the
value of goods and services more than once). In other words, the value of intermediate goods and
services produced by a country should not be included in the calculation of GDP and GNP. All
goods and services produced in a year must be counted only once, but not more than once.
Note (2): GDP measures two important things firstly, the total income of everyone in the
economy, and secondly, the total expenditure on the economy’s output of goods and services.
The income and expenditure of an economy are really same. In short, income must be equal to
expenditure, because every transaction in the economy has two parties namely, BUYER and
SELLER. Every spending of a buyer is an income for some seller.
Example: Jack buys 10 Enjera, by spending his income 20 Birr, and the seller Tomy gets Income
of 20 Birr, by selling the 10 Enjera.
4. Main Features of National Income Concepts:
The main features of the concept of national income are given below:
1. National income is a flow concept and not a stock concept.
2. National income is the goods and services produced by an economy during a period (for
example, a year or six months or a quarter of the year).
 3. National income can be expressed in money terms as it is monetary value of all the final goods
and services produced by an economy during a particular period.
4. National income accounting only includes the goods and services transacted in the market.
This means that non market transacted goods and services are not included.
5. National income accounting includes the rent of our domestic house, where we live.
6. However, national income excludes items produced and consumed at home as these items
never enter in the market. For example, vegetables you buy from the market are part of GDP. But
vegetable you cultivated and consumed in your home is not part of GDP.
6. National income accounting does not include illegal market transactions (for example, illegal
drug selling).
7. National income accounting does not include transaction of existing assets, if it is not adding
value to the current flow of goods and services.
5. Approaches of measuring national income (GDP/GNP)
The national income of a country can be conceptually visualized in three forms (ways) such as 1)
National Output (Value Added Approach), 2) National Income (Income Approach) and 3)
National Expenditure (Expenditure Approach).
6. Product Approach or Value Added Approach
Production of goods and services typically involves a sense of distinct stage. Each stage
involves separate market transaction and flow of income. For example as indicated in table 1.3
below, there are four different stages having their own market transaction in production of bread.
The farmers first grow up the wheat, and then sold to the Miller owners. Then the miller converts
to flour and sell to bread beaker. The bread baker sell to the store owner and store owner sell to
consumer finally.

Table 1. Production of bread involving four different stages.

Stages of production Value of transaction Value added
Farmer grows wheat and sell 12 12
to miller
Miller converts wheat to 28 16
 Flour and sell to baker
The baker bake bread and 60 32
Sell to store owner
The store sells bread to the 75 15
final customer
Total Value when double counted 175 GDP = 75

From the above example, if we add up separate value of each market transaction we would get
the value of output produced in production process equal to 175 Birr. However, we actually
produced output worth equal to 75 Birr. This 75 Birr shows the value added in the process of
production. The above example shows that there is a problem of double count. If we use
intermediate goods and services in the calculation of GDP, we will suffer from the problem of
double counting. Therefore we must distinguish between final goods and services, and
intermediate goods and services before measuring GDP more accurately.

1. Income approach
In circular flow of income, we have discussed that there is a flow of payment for factor inputs
from firms (businesses) to households. This is exactly equivalent to National Income of a
country.
As indicated above if we follow the different route of circular flow of income, it is possible to
come up with different method of measuring GDP of a given economy. It is approaching the
same thing from different angles. In case of income approach the returns (income) to factors of
input such as labour, Land and capital sum up together to arrive at the amount of output
produced in a given economy per unit of time. This is summing up income flow to households
following the top outer arrow of figure 1.1. In this approach, depending up on the owner of factor
input, the components of GDP includes the following:
 Employment compensations payment made for labour in the form of wages and salaries.
 Rents payments for use of land, building and other capital input.
 Interest income received by households on their saving deposit.
 Profit payments made to the owner of firms in return to the output produced after
deduction of cost of production. It is the sum of proprietor profit and corporate profit.
Proprietor’s profit is the net income of proprietorship and partnership, where as corporate
profit undistributed share holder profit which includes corporate income tax, dividends
and retained earnings.
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.
Depreciation represents consumption of fixed capital which can be considered as cost of
production. 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.
Since it is the income generated through production process but not earned by factor owners
indirect business taxes are considered as the income created in the country during the specific
time. In other words, indirect business taxes are income for the government. This implies
indirect business tax and depreciation enter the income side in the process of GDP computation.

The following table represents an example of GDP computation for hypothetical economy using
income approach.
Table 2. GDP of hypothetical economy in billions of dollars
Component of GDP Values in dollars
Wages and salaries $6,657.4
Rents $153.8
Interest rate $ 546.7
Profit $2,020.9
Plus depreciation $ 1,479.9
Plus Indirect business tax $885.9
Plus statistical discrepancy $90.4
GDP $11,835.00
2. Expenditure approach
From the above circular flow of income/product, we have seen that the product side of the
National Accounts measures the flow of currently produced goods and services in the economy.
The flow of goods and services currently produced by the workers are measured by
EXPENDITURES on these goods and services by consumers, businesses, government, and
foreigners. The income side of the National Accounts measures the FACTOR INCOMES that
are earned by the workers of the country, profit paid to owners of capital, earnings of proprietors,
and so on. All expenditures in the economy ends up as someone’s income.
GDP or GNP of a country can be measured by either adding up the total expenditure by
households or by adding up the total income (i.e. wages, rent, profit and interest earned by
capital) paid by firms.
The product and income sides are two different measures of the same continuous flow. The
product side measures expenditures on output. These expenditures then become payments
compensating the factors that produced the output.
The factor incomes then are disposed of in consumer expenditure, tax payment, saving, and
transfer payment to foreigners.
In Expenditure approach, GNP = C + I + G + (X-M).
The left hand side of the identity measures GNP by expenditures on final product.
Where, C = consumption expenditures, I = business expenditure on plant, equipment,
inventories, and residential construction, etc. In other words, it shows gross private domestic
investment.
G = total government purchases of goods and services and (X-M) = net export, i.e. net export
domestically produced.
Expenditure approach to measure National Income is an alternative to income approach.
In this approach, we add up expenditure made on final goods and services in the product market.
Thus we can measure, the GNP as given below:
The above expenditure components show the demand for final goods and services. It is the net
expenditure made on domestically produced goods and services by foreigners, which is income
for domestic producers.
Note: GD of an economy can be calculated by adding up all the expenditure on goods and
services produced in a given economy. For example, the product side of GNP of USA in 1987
has been given in Table 1.2 below:

Table 3. GDP and it components, in $ billions in 1987 for USA

Component of GDP Amount of spending

 Personal consumption expand…………………………………………..$4527.00

o Durable goods……………………………………… $3012.00
o Non-durable goods…………………………………… $422.00
o Services goods…………………………………………$998.00
 Business investment……………………………………………………..$1607.00
o Business fixed investment ……………………………$713.00
o Structures………………………………………………$447.00
o Producers durables……………………………………. $140.00
o Residential Structure………………… ………………. $307.00
  Government spending………………………………………………….....$1307.00
Federal Gov’t spending…………………………………..$382.00
National defence……………………………………$295.00
Others…………………………………………………...$ 87.00
State and local………………………………………$543.00
 Net export…………………………………………………………………..$-69.00
o Exports……………………………………………….…$482.00
o Import…………………………………………………..$551.00
Total (i.e. GDP).,…..…………………………………………..……… $ 7,372

3.2. Nominal and real GDP

The aggregate goods and services measured at current market price are called nominal GDP.
For example, consider an economy, which produces only two goods such as banana and coffee.
To find the nominal GDP of such economy, simply sum up the total value of banana and coffee at
current market prices.
That is, nominal GDP = (Price of banana in current year x Quantity of banana in current year) +
(price of coffee in current year x Quantity of coffee in current year).
The problem with such type of valuation of goods and services is that it could not reflect the
cause for change in GDP resulted from change in price or change in quantity of output
overtime. There are cases where GDP changes without any change in amount of output of an
economy when there is change in prices.
For illustration consider the prices and amount of output (banana and coffee) produced
from 2004 to 2007 for the hypothetical economy as given in table 4 below:
Table 4 the total amount of output of two goods economy with their market prices of hypothetical
economy.

Year Price of Quantity of Price of Quantity of coffee(tone)

banana/kg banana(tone) coffee/kg
2004 2.00 10,000.00 5.00 20,000.00
2005 2.50 10,500.00 8.00 20,500.00
2006 3.00 10,600.00 10.00 20,600.00
2007 5.00 10,600.00 30.00 20,600.00

Let us compute the nominal GDP of the economy for 2006 and 2007 to see the impact of price
on the value of total output (GDP).
Nominal GDP of 2006 = (2006 price of banana x 2006 amount of banana) +
(2006 price of Coffee x2006 amount of coffee).
= (3x10, 600) + (10x20, 600)
= 31,800+206,000
=237,800

Nominal GDP in 2007 = (2007 Price of banana x 2007 amount of banana) +

(2007 price of banana x amount of coffee in 2007)
= (5x10, 600) + (30x20, 600)
=53,000+618,000
=671,000

This example show that the nominal GDP in 2007 increases without an increase in the amount of
output produced because of increase in price. Therefore, it is misleading to use nominal GDP to
say something about the performance of the economy (growth)
A better way of measuring the state of an economy is measuring the economy’s total output by
avoiding the impact of price. This can be possible by using real GDP. Real GDP is the value of
goods and services measured using constant or base year price. It is computed after adjusting for
change in price from year to year. Therefore, to compute real GDP first set a base year price and
then value all the output produce in different year at the selected base year price. For instance,
let us set a base year price for the above hypothetical economy to be 2004, then the real GDP of
2006 and 2007 can be computed as follows.
Real GDP= (2004 price of banana) (2006 Quantity of banana) + (2004 price of coffee)
(2006 Quantity of coffee)
= (2x10, 600) + (5x20, 600)= 21,200+103000=124,200
Real GDP= (2004 price of banana) (2007 quantity of banana) + (2004 price of coffee) (2007
Quantity of coffee)
= (2x10, 600) + (5x20, 600) =21,200+103,000= 124,200
When price held constant, the real GDP varies from year to year only when the quantities
produced vary. Thus real GDP measure changes in physical output in the economy between
different time periods by valuing all goods produced in two periods at the same prices. This is
done in order to make GDP in different periods comparable and able to identify the real changes
in the amount of goods and services produced in different time. In the above example between
2006 and 2007 there is no change in the amount of goods produced. The calculate GDP also
reflects the same thing.

GDP Deflator

GDP Deflator is the ratio of Nominal GDP to Real GDP times 100.

i.e. = [Nominal GDP/ Real GDP.] x 100.

GDP deflator shows what happening to the overall level of prices in the economy. GDP deflator
is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It
shows what happening to the overall level of prices in the economy. The GDP deflator is the
comprehensive price index for GDP.

Nominal GDP = Real GDP x GDP deflator.

We can calculate the GDP deflator based on the data given in table 4 above.
GDP deflator for year 2006 computed as:

GDP Deflator of 2006 = i.e. = [Nominal GDP in 2006/ Real GDP in 2006] x 100.

= [237,800/ 124,200] x100 i.e. = 191.5

This means there is an increase general level of price by 191.5 percent in 2006 relative to general
price of 2004.

Other measures of output/income

Alternative to GDP, there are other measures that are used to represent the total output produced
in an economy. Let us identify how to determine these measures based on GDP.
 Net domestic product (NDP) –It represent the value of total output of an economy after
net out depreciation.
NDP=GDP - depreciation.
 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).
NNP=GNP – Depreciation
  National Income (NI) – It is the total income earned by resource owner from current
production. National income can be computed in two ways. First, by summing up the
factor incomes earned in producing total output. Second, by making adjustment to net
national income through subtracting indirect business tax from NNP.

NI= NNP-Indirect business tax (e.g. sales tax)

NI= GNP - Depreciation – Indirect business tax
NI=wages and salaries + proprietors income + Rental income +corporate
profit +Interest income.
National income can be also determined from NDP after making adjustment for net foreign
income. It is the difference between incomes generated by foreigners found in domestic economy
in return to their factor input and income earned by domestic citizen abroad in return to factors
input.
NI= NDP-Indirect business tax +net foreign factor income
 Personal income is the amount of income that households and non corporate businesses
receive. It can be obtain from national income after series of adjustment. First reduces
from the national income the amount of corporate earnings but add payments to its share
holders (retain earning and taxes). Secondly increase the national income by the amount
government pay transfers to individuals. Thirdly, national income is adjusted for interest
rate that households earn rather than interest rate paid by firms.
Personal income (PI) =National Income-corporate profit
- Social Insurance contributions.
- Net interest
+ Dividends
+ Government transfer
+ Personal interest income
 Disposable personal income- Households non corporate business income that is really
to spend after tax and non tax payments. Disposable income would be either consumed
or saved.
Disposable income (DI) = personal income-Personal tax and non-tax payments
DI = consumption + saving
 GDP and Wellbeing (welfare)
GDP measures both income and expenditure in the economy.
Per capita GDP = GDP/ Total Population in the country.
Per capita GDP tells us the income and expenditure of the average person in the economy. Most
people prefer to get high income and thus, high expenditures.
Criticisms:
As the US senator Robert Kennedy point out that
1. GDP does not allow for the health of children of the country.
2. GDP does not allow for quality of their education.
3. GDP does not allow for joy of their play, does not allow beauty of poem.
4. GDP does not allow for strength of marriages.
5. GDP does not allow for intelligence of public debate and integrity of public officials, etc.
It is criticised that GDP measures everything, in short, except that which makes life worthwhile,
it will tell everything except why we are proud of ourselves.
Despite of the above criticism, GDP help us to lead a good life. It is true that GDP is not
measuring health of the children, but high GDP help us to set up hospitals, education institutions,
etc.
1. GDP would help us to enjoy poetry, nurture intelligence, live with integrity, wisdom,
courage, devotion to country, etc.
2. GDP does not measure those things that make life worthwhile, but it measures our ability
to obtain the inputs into a worthwhile life.
3. GNP does not measure value of goods and services that is traded outside the market.
4. It excludes the quality of the environment.
5. It says nothing about distribution of income among various sections of the population in
the country.
Finally, we can conclude that GDP is a good measure of economic well-being for most things,
but not all things.

Business Cycle: Fluctuations in economic activity such as production/employment of the

country overtime. Business cycle may go through different phases.
Economic growth occurs overtime. For instance, on average, the US economy experienced 3 %
growth in their GDP over the past 50 years.
However, in some years this normal growth does not occur. Firms find difficulty to sell their all
goods and services in the market.
So, they cut production.
Result: Workers are laid off, unemployment rises, and factors are laid idle.
GDP falls. Such a period of falling incomes and rising unemployment is called Recession (if
such falls are mild). If such falls are more severe, then it is called Depression.
Recovery: If business is going well, the firm will hire new employees, provide job to the old
employees and they produce goods and services.
Many customers purchases goods/services. Therefore, Economic activities expand. Thus, sales of
businesses increase/ profit also increase.
Production increases due to: Increase in labor force, increase in capital stock, advances in
technological knowledge. So, the economy can produce more overtime.
Prosperity & Boom: At the peak of recovery, the business reaches to at prosperity period and
finally reaches to BOOM.
Stagnation: It may be the beginning of the recession, which is characterized by lack of new job
opportunities, static nature of output growth, etc.
Different Phases of Business Cycle

Peak or boom refers to the highest level of aggregate output or GNP over a period of time. Peaks
imply that at these points the economy performs at or close to full capacity and that it opens up
greater job opportunities
During recession, business persons lose confidence, and cut production. Unemployment
rises and income falls, prices decline.
 The point in which a recession ends and recovery begins is called a trough. Although
employment and incomes are still too low, everybody begins to rebuild hope believing that the
economy cannot get any worse.
Recovery (expansion) is a prolonged journey. It is built on the revival of business confidence
from which everything else springs. In this phase, production, the number of jobs, incomes and
demand gradually increase.
The line from the origin shows the trend growth, long run change in the level of output
over time when full employment of resources is achieved. The deviation of output from the
trend level (Output gap) shows the change in level of employment of resources from full
employment level. Positive output gap shows over employment of resources and utilization of
improved method of production.
KEY FACTS
SHORT RUN FLUCATUATION (BUSINESS CYCLE) OCCURS EVERYWHERE (Look at the
history of various countries).
1. Irregular and Unpredictable
Fluctuations are correspond to BUSINESS CONDITIONS
When real GDP grows rapidly,
Business is good
Many customers purchases goods/services
Economic activities expand
Profit increase/ Sales increase
Production increases due to:
Increase in labor force, increase in capital stock, advances in technological knowledge.
So, the economy can produce more overtime.
When Real GDP falls (during recession)
Businessmen have troubles
Economic Activity contracts
Sales decrease
Loss increase
Sometime B-C is frequent, shorter, and sometime it is not so.
Example: US economy was under recession during 1980- 1982.
No recession during 1991-2001.
2. Most Macroeconomic Quantities Fluctuates Together
Real GDP is the most commonly used economic activity used to monitor short run changes in the
economy.
GDP; Value of goods and services produced within a country in a given period.
Corporate profits
Consumer spending
Investment spending
Industrial production
Retail sales
Home sales Auto sales, etc
Note: These factors may fluctuate by different amounts.
3. As output decreases, unemployment rises.
Changes in output are strongly correlated with economy’s utilization of its labor force.
Firms produce smaller quantities (Look at data!)

Types of Unemployment
Voluntary Unemployment: If any section of labor force is not willing to work at the existing
wage level is known as Voluntary Unemployment. In every economy, some section of people
may not be ready to work at the existing wage level even if job opportunities exist.

Involuntary Unemployment: If any section of labor force is willing to work at the existing
wage level, but they are unable to find a job at the existing wage level, which is known as
Involuntary Unemployment. Full employment means zero level of involuntary unemployment.
Therefore, full employment does not mean that unemployment is zero.

Structural Unemployment: This is the situation where supply of labor exceeds demand for
labor. In this case, there is a mismatch between the number of people who want to work and the
number of jobs that are available in the economy.
This type of unemployment arises due to: Lack of technical skill of the people. The unemployed
workers may lack the skills needed for the jobs.
This may also arise due to technical change such as automation, or from changes in the
composition of output due to variations in the types of products people demand. For example, a
decline in the demand for typewriters would lead to structurally unemployed workers in the
typewriter industry.

The structural unemployment is permanent types of unemployment; improvement is possible

only in the long run.

Cyclical Unemployment: Workers may lose their jobs due to fluctuations in output, i.e. due to
the business cycle in the economy. Up (prosperity and boom) and down (recession and
depression) may occur in the economy due to business cycle as a result workers lose their job.

Seasonal Unemployment: Some sectors of the economy only provide job in some seasons. For
example, seasonal unemployment exists in agriculture sector. During the period of cultivation the
farmer may be employed and after harvest they become unemployed.

Frictional Unemployment: People may quit job very often to find a better job (people move or
change job). Once a person quit a job he/she has to find a job and there may be a gap to find a
new job. Then the person is frictionally unemployed, because even if job opportunities exist due
to lack of information they person may not be able to find a job.
During recession, frictional unemployment tends to be low since workers become afraid of
quitting their job to find a better job. They have poor chances of finding another good job as
people that already have another job lined up to find a job; because they may be facing laid off or
shut down of their firms and harder to find a new job.

Disguised Unemployment: This is the unemployment arise from the fact that even though the
person/individual is employed, his/her labor productivity is zero. Eg: Agricultural Sector, where
the marginal productivity is zero or negative.

3 Unemployment Rate

Labor Force = No. of employed + No. of Unemployed.

Unemployment Rate = [No. of Unemployed / Labor Force] x 100.

Labor Force Participation Rate = [Labor Force /Adult Population] x 100.

Natural rate of unemployment
As we said, only cyclical unemployment is a direct result of the economy’s weak performance.
The other forms of unemployment, however involve other variables outside of the economy.
Such a contention led economists to the conclusion that at any point in time there may be some
people in the work force who remain unemployed even if the economy is functioning without
difficulty. This is what we mean by natural rate of unemployment.
Mathematically,

Natural rate of unemployment= [No. of unemployed – No. of cyclically unemployed] x100.

Total work force

= [Number of frictionally, seasonally, and structurally unemployed] x100.

Total work force
Cost of unemployment
Some of inflation controlling measures we seen previously results in increase in unemployment.
This kind of situation creates a dilemma for policy makers as to whether or not to control
inflation. Therefore, the cost of inflation should be identified and compared with the cost of
unemployment to choose optimal policy that used to manage the economy.
Employed workers produce goods and services whereas unemployed workers do not. Thus
an increase in the unemployment rate decreases the real GDP of an economy.
The other cost of unemployment is that it reduces living standard and causes psychological
distress. Unemployment has also income distribution effect. It causes inequality among
employed and unemployment workers.

Fluctuations in General Price Level

Inflation: This is increase in the general price level in the economy.
Deflation: This is decrease in the general price level in the economy.
Disinflation: Disinflation is decrease in the rate of inflation. This means that a slowdown in the
rate of increase of the general price level of goods and services. It is the opposite of
REFLATION. Disinflation occurs when the increase in the “price level” slows down from the
previous period when the prices were rising.
Stagflation: Stagflation is the coexistence of stagnation (stagnation in the production) and
inflation (increase in the price level) in an economy.
 Price Level: Consumer Price Index
The CPI turns the prices of many goods and services into a single index measuring the overall
level of prices.

Measurement of CPI:

CPI = (Prices of basket of commodities in the current year/ Prices of the same basket of
commodities in the base year) x 100.

Example: Consumers in an economy buy 5 Apples and 2 Oranges. Then the CPI can be
measured as:

CPI = [(5 x Price of Apple in 2014) + (2 x Price of Oranges in 2014)]/ [(5 x Price of Apples in
2009) + (2 x Price of Oranges in 2009].

In the above example, 2009 can be considered as a base year. The CPI tells us how much it costs
now (eg: 2014) to buy 5 Apples and 2 Oranges relative to how much it costs to buy the same
basket of fruits in 2009.

CPI is the most used price index.

Rate of Inflation = {[CPIt – CPI(t-1) previous year] / CPI previous year }x 100

Where, t = current (present) time period and (t-1) is the previous year.

Other price indices are: Wholesale Price Index (WPI) - (Prices of goods and services that a
shop owners buy), and Producer Price Index (PPI)- (Prices of goods and services that a firm
buys).

Cause of inflation:
There are two broad types of inflation. 1) Demand pull inflation and 2) Cost push inflation. The
AD–AS diagram can be used to explain various macroeconomic phenomena such as
INFLATION.

Inflation due to Demand pulls factors.

Demand pull inflation is the result of rapid increase in demand for goods and services than
supply of goods and services (fixed level of goods and services supplied). Suppose demand
(DD) for goods exceeds supply (SS) there is an INFLATIONARY GAP where DEMAND-
PULL INFLATION occurs. Therefore, the AD curve shifts upward to a higher price level.

Inflation due to Cost push (supply side) factors

Suppose an economy faces higher costs, COST-PUSH INFLATION occurs. Therefore, the AS
curve shifts upward to higher price levels. The AS–AD diagram is also widely used as
pedagogical tool to model the effects of various macroeconomic policies. Cost push inflation
occurs when different factors which increases cost of production (increases price of input) and
other structural bottle neck cause firms to reduce the supply of goods and services below existing
demand. One factor which cause decline in supply of goods and services at on going demand is
increase in price of input like labour, oil and other raw material.
Effects of inflation
�m �
1. Generally inflation reduces real money balance � �or purchasing power of money.
�p �
Since it reduces the purchasing power of money, inflation reduces the welfare of individuals.
For example, if an increase in income by 6 percent causes inflation rate of 8 percent, then
purchasing power (the amount of goods and service you can buy with the same amount of
money) your income decreases by 2 percent as a result of increase in price emanated from
increase in income.
2. Inflation increases uncertainties about macroeconomic policy and adversely affects the
public decision making ability. Inflation is an indicator of the overall inability of
government to manage the economy.
3. Unanticipated inflation hurts individuals with fixed income (pension).
4. The case of debtors and creditors: inflation is a friend of debtors and an enemy of
creditors. If there is a significant level of inflation in the economy, the debtors pays less
amount of money in real terms than he borrowed earlier.
Some economists believe that moderate level of inflation (2 to 3) per cent per year is good to
stimulate the economy. That is a moderate level of inflation reduces real wage (w/p) and then
increase level of employment (decreases unemployment). Therefore to increase labour supply
cutting of nominal wage is not possible to decreases real wage. The only way to decrease real
wage is to allow inflation to do the job. Increase in nominal wage will be taken as an increase in
their real wage and hence increase labour supply and then output.
Such relationship between nominal wage and level of unemployment can be represented by a
curve known as Philips curve as indicated in figure 1.4 below. According to Phillips curve,
when unemployment rate is reduced, the rate of inflation rises (look at the US economy during
1965-66). Wage inflation
(Price)
Figure 1-4 the Philips
curve
 ← Philips curve

Unemployment

Philips curve shows the trade-off between unemployment and inflation. That is when the rate of
wage decreases, unemployment rate increases.

Potential GDP and Actual GDP

Potential GDP is the amount of GDP at full employment level (i.e. GDP that would be produced
with some unemployment rate that is consistent with non-inflationary labour market equilibrium.
Actual GDP is the amount of GDP actually produced by a country (realized GDP).

GDP Gap: The gap between potential GDP and actual GDP is known as GDP Gap.

Okun’s Law

What relationship should we expect to find between unemployment rate and real GNP growth
rate?

Arthur Okun studied the relationship between rate of unemployment and Changes in real GNP
and he finds that increase in unemployment is associated with decrease in real GNP. This
negative relationship is called Okun’s Law. Okun found that approximately, 3 % increase in the
real GNP will leads to 1% decrease in the rate of unemployment in the economy. This also
suggests that level of unemployment is depends on level of output in the economy.