University of Gondar

College of Business and Economics

Scool of Economics
PPT Compiled for Macroeconomics I

By Eshetie Woretaw

Gondar, Ethiopia
2013 E.C

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CHAPTER TWO

NATIONAL INCOME ACCOUNTING

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Is an accounting record of the level of economic
activities of an economy
is a measure of aggregate output, income and
expenditure in an economy
The aggregate monetary value of all final goods and
services produced in a country during the year.
Only final g +s are included

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Measurement issues
• An economic variable, when measured, has two properties; time
dimension and accounting unit.
• Based on the time dimension of measurement, we can have two
types of variables.
• Stock: refers to the value of goods & services at a
particular point of time, constant. It is an entity that is
accumulated over by inflows and/or depleted by
outflows. Therefore, we can say that the 'stock' can
only be changed by a 'flow'.
• 'Stocks' typically have a certain value of each moment
of time, for example the size of population at a certain
moment.
•

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 Cont.

• Flow: is change in stock over period of time. Change

refers to inflows (adding to the stock) and outflows
(subtracting from the stock).
• Flows typically are measured over a certain interval of
time. For example the increase in population due to
increase in number of births.
• Flows: whre values of variables are changing as time
passes
• To conclude we may say that 'Stock' is a Static concept
whereas 'Flows' represents Dynamic concept.

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Cont.
• Stock
1) Wealth,
2) Debt,
3) Capital
4) Unemployment
• Flow
1). Expenditure, income
2) Fiscal deficit
3)Number of persons losing jobs
4) Investment

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2.1 Measurements National Income

National Income is defined differently by different

economist.

Different views are adopted by different economists to

define national income.
These are:
• The Traditional view
• The Keynesian view
• The Modern view

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In the traditional view, national income is defined as:

‘’Services as received by ultimate consumers, whether

from their material or from their human environment'' Fisher I.

From this definition, the economist adopts

consumption as the basis of national income.

But it is not an easy task to measure net consumption

and the value of services rendered by consumer
durables year after year.
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• ''The labour and capital of country acting on its natural
resources produce annually a certain net aggregate of
commodities (material and immaterial) including services
of all kind. This is the true net national income or revenue
of the country or national dividend'' Marshal A.

• According to him, it means that all types of goods and

services which are produced, whether they are
brought to the market or not, are included in the
national income.

• He added that the depreciation should be deducted from

the total value of these goods and services.
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• He also took in account income from abroad while
calculating the national income.

• ''National income is that part of the objective income of

the commodity, including of course, income derived from
abroad which can be measured in money'' Pigou.

• It means that only goods and services exchanged for

money are included in the national income.

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In the Keynesian view, national income is defined with
respect to three approaches:
• The Expenditure Approach: here, national income is equal
to total consumption expenditure and total investment
expenditure systematically i.e.Y=C+I where Y is national
income, C is consumption expenditure and I is total investment
expenditure

• The Income Approach: here national income includes the

total income of all factors of production i.e.Y=F+EP where Y
refers to national income, F is the payments received by
owners of factors of production and EP is entrepreneurial
profits.

• Sale minus Cost Approach: in this approach national

income(Y) is equal to total sales of proceeds (A) less user cost
(U) i.e. Y=A-U
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• In the modern view any of the following three
approaches may be used to determine national income of
a country namely;
oProduct approach,
oIncome approach or
oExpenditure approach.

• The modern approaches are discussed in detail with the

help of numerical examples in the next section.

• In all cases two measurements of national income

are discussed.

• These are gross domestic product (GDP) and gross

national product (GNP).
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Gross domestic product [GDP]- is the market value of
all final goods and services produced within an economy in
a given period of time.

There are two ways to view this statistic.

i) GDP is as the total income of everyone in the economy.
ii) GDP is as the total expenditure on the economy’s
output of goods and services.

From either viewpoint, GDP is a measure of economic

performance. GDP measures peoples’ incomes.

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How can GDP be measured using both the economy’s income and
the expenditure on its output?

The two quantities are the same: for the economy as a whole,
income must equal expenditure.

Because every transaction has both a buyer and a seller, every Birr
of expenditure by a buyer must become a Birr of income to a
seller.

Eg.When Abebe paints Kebede’s house for Birr 1,000, that Birr 1,000 is
income to Abebe and expenditure by Kebede.The transaction contributes
Birr 1,000 to GDP, regardless of whether we are adding up all income or
adding up all expenditure.
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Imagine an economy that produces single good, bread, from a
single input, labour.

The Figure below illustrates all the economic transactions that

occur between households and firms in this economy.

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GDP measures the flow of money in this economy.

To compute GDP, we can look at either the flow of money from firms
to households or the flow of money from households to firms.

Every transaction that affects expenditure must affect income, and

every transaction that affects income must affect expenditure.

For example, suppose that a firm produces and sells one more loaf of
bread to a household. Clearly this transaction raises total expenditure
on bread, but it also has an equal effect on total income.

If the firm produces the extra loaf without hiring any more labour
(such as by making the production process more efficient), then profit
increases. If the firm produces the extra loaf by hiring more labour,
then wages increase. In both cases, expenditure and income increase
equally.
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Gross National Product [GNP] is the value of goods and
services produced by nationals (citizens) of a country.

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 Receipts From Abroad -

Factor Payments to Abroad.

GNP = GDP + Net Factor Income.

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Cont.
• GNP = GDP + net income from a broad
GNP = GDP + (I1 – I0 )You can observe the following
relationship:

 When Ii > I0 , GNP exceeds GDP

When Ii = I0 , GNP equals GDP
When Ii<I0, GNP is less than GDP

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 2.1 Approaches to National Income Accounting
Process
Rules for Computing GDP
1) Used Goods
GDP measures the value of currently produced goods and
services.

The sale of used goods reflects the transfer of an asset, not

an addition to the economy’s income.

Thus, the sale of used goods is not included as part of GDP.

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2) The Treatment of Inventories

The goods and services produced in an economy may not be sold

in the year they are produced. Instead, they are put into
inventory to be sold later.

In this case, the owners of the firm are assumed to have

“purchased’’ the goods for the firm’s inventory, and the firm’s
profit is not reduced by the additional wages it has paid to
produce the goods.

Because the higher wages raise total income, and greater

spending on inventory raises total expenditure, the economy’s
GDP rises.
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What happens later when the firm sells the goods out of
inventory?

This case is much like the sale of a used good. There is spending by
consumers, but there is inventory disinvestment by the firm.

This negative spending by the firm offsets the positive spending by

consumers, so the sale out of inventory does not affect GDP.

The general rule is that when a firm increases its inventory of goods, this
investment in inventory is counted as expenditure by the firm owners.
Thus, production for inventory increases GDP just as much as
production for final sale. A sale out of inventory, however, is a
combination of positive spending (the purchase) and negative spending
(inventory disinvestment), so it does not influence GDP.

This treatment of inventories ensures that GDP reflects the economy’s

current production of goods and services.
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3) Intermediate Goods and Value Added
Many goods are produced in stages: raw materials are processed
into intermediate goods by one firm and then sold to another
firm for final processing.

How should we treat such products when computing GDP?

For example, a flour mill sells flour for Birr 350 to a baker who
produces 1000 loafs of bread and sells each loaf of bread for Birr
0.50. Should GDP include the value of flour and bread or only
the value of bread?

 GDP is the total value of final goods and services produced.

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

The value added of a firm equals the value of the firm’s output
less the value of the intermediate goods that the firm purchases.

In the case of the bread, the value added of the flour mill is Birr
350 and the value added of the baker is Birr 150 (Birr 500 – Birr
350). Total value added is Birr 350 + Birr 150, which equals Birr
500.

For the economy as a whole, the sum of all values added must equal
the value of all final goods and services.

Hence, GDP is also the total value added of all firms in

the economy.

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4) Housing Services and Other Imputations

Although most goods and services are valued at their

market prices when computing GDP, some are not sold in
the marketplace and therefore do not have market prices.

If GDP is to include the value of these goods and services,

we must use an estimate of their value (imputed
value).

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Imputations are especially important for determining the value of
housing.

A person who rents a house is buying housing services and providing

income for the landlord; the rent is part of GDP, both as
expenditure by the renter and as income for the landlord.

Many people, however, live in their own homes. Although they do not
pay rent to a landlord, they are enjoying housing services similar to
those that renters purchase.

To take account of the housing services enjoyed by homeowners, GDP

includes the “rent’’ that these homeowners “pay’’ to themselves.

This imputed rent is included both in the homeowner’s expenditure

and in the homeowner’s income.
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Imputations also arise in valuing government services.
For example, police officers and fire-fighters provide
services to the public.

Giving a value to these services is difficult because they are

not sold in a marketplace and therefore do not have a
market price.

The national income accounts include these services in

GDP by valuing them at their cost. That is, the wages of
these public servants are used as a measure of the value of
their output.

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In addition, some of the output of the economy is
produced and consumed at home and never
enters the marketplace.

For example, meals cooked at home are similar to meals

cooked at a restaurant, yet the value added in meals at
home is left out of GDP.

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2.2.1. The Output Approach
This is a method of measuring gross national product by
adding up the market value of output of all firms in
the country.

In this method of measuring GDP, it is important to include

only final goods and services in order to avoid double
counting.

Double counting arises when the output of some firms are

used as the inputs of other firms.

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There are two ways of avoiding this problem.

These are;
- taking only the value of final goods and services or
- taking the sum of the added value of firms at different
stages of production.

The following table shows how the total output of the

economy is determined for Ethiopia.

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 Sectors Value of Output (in million Birr)
1) Primary Sector
a) Agriculture 33559.92
b) Forestry 2664.03
c) Fishing 1146.73
Subtotal 37365.68
2) Secondary Sector
a) LMS Industries 5743.24
b) Construction 4566.92
c) Electricity and Water 456.69
d) Mining 304.46
Subtotal 11071.31
3) Territory Sector
a) Banking and Insurance 16399.38
b) Education 2283.46
c) Health 1037.94
d) Defence 415.17
e) Other Service 622.76
Subtotal 20758.71

Gross Domestic Product 69195.70

4) Net Income from Abroad (9195.70)

Gross National Income 30

60000.00
2.2.2 The Expenditure Approach
Economists and policymakers care not only about the
economy’s total output of goods and services but also about
the allocation of this output among alternative uses.

The national income accounts divide GDP into four broad

categories of spending:
• Consumption (C)
• Investment (I )
• Government purchases (G)
• Net exports (NX).
Thus, letting Y stand for GDP,
Y = C + I + G + NX.
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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 identity.

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Consumption consists of the goods and services bought by
households.

It is divided into three subcategories:

-nondurable goods,
-durable goods, and
-services.

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Investment consists of goods bought for future use.

Investment is also divided into three subcategories:

- business fixed investment - is the purchase of new
plant and equipment by firms.

- residential fixed investment - purchase of new housing

by households and landlords.

- inventory investment - the increase in firms’

inventories of goods (if inventories are falling,
inventory investment is negative).

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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.
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The last category, 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.

The following example helps you know how to calculate

GDP/GNP using the expenditure approach.

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 Example 1
Given the following information for a hypothetical
economy (in millions of Birr), calculate GDP of this
economy.
• Let GDP = y, C= 100+0.1y, Ig= 0.5C, G= 2000, X=
600, M= 0.2X
• Solution: Y= C + Ig + G + X –M
Y=100+0.1y+0.5(100+0.1y)+2000+600-0.2(600)
0.85Y=2630
Y= 3094

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Expenditure Components Value (in million Birr)
1) Consumption Expenditure 52192.9

1) Gross Investment Expenditure 21548.7

Less Depreciation 5904.4

15644.3
1) Government Purchases 15052.5
1) Exports 5232.6
1) Imports 18926.6
13694.0
Gross Domestic Product 69195.70

1) Income to Foreigners 14769.5

1) Income to Nationals 5573.8
(9195.7)

Gross National Income 60000.00

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2.2.3 The Income Approach
National income measures how much everyone in the
economy has earned.

The national income accounts divide national income into

many components, depending on the way the income is
earned.

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.
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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 foreigners.

Depreciation (Capital Consumption Allowance) (D): the annual

payment, which estimates the amount of capital equipment used up in each
year's production, is called depreciation. It represents a portion of GNP
that must be used to replace the machinery and equipment used up in the
production process.

Indirect Business Tax (IBT): the government imposes indirect taxes

on business firms. These taxes are treated as cost of production. Therefore,
business firms add these taxes to the prices of the products they sell.
Indirect business tax includes sales taxes, excise taxes and custom duties.
The following example helps you know how to calculate GDP/GNP using
the income approach.
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Types of Income Value (in million Birr)
1) Compensation of Employees 45623.71
2) Rental Income 1249.32
3) Proprietor’s Income 10561.21
4) Corporate Profits 16960.33
Subtotal 27521.54
5) Net interest 5189.73
6) Depreciation 521.84
7) Indirect Business Taxes 476.51
8) Subsidy 11368.95
Gross Domestic Product 69195.70
9) Income from abroad 2036.20
10) Payments to abroad 11231.90
(9195.70)
Gross National Income 60000.00

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Other Measures of Income
Other measures of national income include:

•Net National Product (NNP),

•National Income (NI),
•Personal Income (PI) and
•Personal Disposable Income (PDI).

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1. 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.

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.
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2. National Income (NI): the next adjustment in the
national income accounts is for indirect business taxes, such as
sales taxes.

These taxes, 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 national income.

National Income = NNP - Indirect Business Taxes + Subsidy

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3. Personal Income: It is the amount of income received by
households and non-corporate businesses.

Personal Income
= National Income - Corporate Profits
- Social Insurance Contributions
- Net Interest
+ Dividends
+ Government Transfers to Individuals
+ Personal Interest Income

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4. Personal Disposable Income (PDI): is the amount of
income households use for either direct consumption or
saving.

It is calculated as the difference between Personal Income

and Personal Income taxes such as income taxes, property
taxes and inheritance taxes.

Personal Disposable Income (PDI)

= Personal Income (PI) - Personal Taxes (PT)

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Real GDP versus Nominal GDP
Is nominal GDP a good measure of economic well-being?

Consider an economy that produces only apples and oranges. In

this economy GDP is the sum of the value of all the apples
produced and the value of all the oranges produced.

That is,
GDP = (Price of Apples × Quantity of Apples) + (Price of
Oranges × Quantity of Oranges).

Notice that nominal GDP can increase either because prices rise
or because quantities rise.
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It is easy to see that GDP computed this way is not a good measure of
economic well-being.

That is, this measure does not accurately reflect how well the
economy satisfies the demands of households, firms, and the
government.

If all prices doubled without any change in quantities, GDP would

double.

Yet it would be misleading to say that the economy’s ability to satisfy

demands has doubled, because the quantity of every good produced
remains the same.

The value of goods and services measured at current prices

is called nominal GDP.

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A better measure of economic well-being would tally the
economy’s output of goods and services and would not be
influenced by changes in prices.

For this purpose, economists use real GDP, which is the value of
goods and services measured using a constant set of prices.

That is, real GDP shows what would have happened to

expenditure on output if quantities had changed but
prices had not.

The nominal GDP can be converted to real GDP by using GDP

deflator. It is a type price index that deflates nominal GDP to
its real value.
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The GDP deflator may be defined as the ratio of nominal
GDP (GDP measured in current prices) and real GDP
(GDP measured in base year prices).

Since the GDP deflator is based on all goods and services

produced of the economy, it is a widely used price index. It
measures the change in price that has occurred between the
current year and the base year.

To compute today’s real GDP; today’s output [nominal

GDP] is multiplied by the ratio of prices of that year and in
the base year. Suppose we use the price level in 2002 as the
base year price to measure real GDP in 2003 and 2004.
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Real GDP for 2002 would be
Real GDP = (2002 Price of Apples/ 2002 Price of Apples × 2002
Quantity of Apples)
+ (2002 Price of Oranges/ 2002 Price of Oranges× 2002
Quantity of Oranges)

Similarly, real GDP in 2003 would be

Real GDP = (2003 Price of Apples/2002 Price of Apples × 2003
Quantity of Apples)
+ (2003 Price of Oranges/2002 Price of Oranges × 2003
Quantity of Oranges)

And real GDP in 2004 would be

Real GDP = (2004 Price of Apples/2002 Price of Apples × 2004
Quantity of Apples)
+ (2004 Price of Oranges/2002 Price of Oranges × 2004
Quantity of Oranges).
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Notice that 2002 prices are used to compute real GDP for
all three years.

Because the prices are held constant, real GDP

varies from year to year only if the quantities
produced vary.

Because a society’s ability to provide economic satisfaction

for its members ultimately depends on the quantities of
goods and services produced, real GDP provides a better
measure of economic well-being than nominal GDP.

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Cont.

53
 Cont.
Eg. The Ethiopian nominal GDP and the CPI for the year
1985 and 1986 was given below. Calculate the real GDP
and the economic growth?

Economic growth = RGDPt – RGDPt-1 x 100

RGDPt-1
5.1 %

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Consumer’s price index (CPI)

• Measures of the cost of living

• Inflation or deflation is derived from a price index;
a price index is a number that shows how the
average level of prices has changed over time.
• To create a price index assign one year as
the base year.
• We determine all changes in prices from that base
year then weight the change
in price for each good by the year as assigned a
value of 100.

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• The price index for years other
the base year indicates the change in the average
level of prices between any year and the base
year, which can be expressed as percentage
changes.
•

56
Cont.

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 2.3. Difficulties in Measuring
National Income
The calculation of national income is not an easy task. The
difficulties faced are as follows.

1. Definition of a nation: 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.

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2. Stages of economic activities: it is also difficult to
determine the stages of economic activity at which the national
income is determined i.e. whether the income should be
calculated at the stage of production or distribution or
consumption.

It has, therefore, been agreed that the stage of economic activity

may be decided by the objective for which the national income
is being calculated.

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.

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3. Transfer payments: this also poses a great difficulty in
the way of 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.

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4. 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.

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5. Inadequate data: in all most all the countries,
difficulty has been faced in the calculation of national
income because of the non-availability of adequate data.
Sometimes, the data are not reliable.

This is a general difficulty and may not be solved.

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6. 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.

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7. 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.

For example, changes in the price of capital goods from

year to year, the age composition of capital stock,
depreciation in cost due to the use of the capital stock,
etc.

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8. Price level changes: 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.

But then, the problems of constructing price index numbers

will arise.

65
Importance of National Income
Statistics
National income statistics are of great importance.

With the help of these statistics one may know the state of
the economy’s performance.

Some of the importances of national income statistics are

given below.

66
1. Indices of national welfare: national income
statistics are useful indices of the economic welfare of
the people.

With their help, one can very easily draw a comparison

between the economic conditions of the people living in
different countries and of those living within the
country at different periods of time.

These statistics are very useful for knowing the changes in

the standard of living of the people all over the world.
67
2. Aid to economic policy and planning: national
income statistics are pointers to the changes in the
economic activities taking place in the economy under
the impact of various policies of the government.

Whether a particular policy has yielded the desired results

or not may be known by the national income statistics.

And on the basis of the studies and researches conducted

with the help of these statistics, the policy makers may bring
about suitable changes in their policies.

They also provide important tools for economic planning.

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3. Index of economic structure: national income
statistics are very useful indices of the economic structure
of a country.

They provide useful knowledge about the performance of

various sectors of the economy.

Thus, one can have a clear idea of the sectors which are
lagging behind in economic development and the sectors
which are advancing in economic growth.

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4. Useful pace for the formulation of budgetary policies:
national income statistics provide a very useful and important
base for the formulation of government budgets.

It is on the basis of these figures that the finance minister is able to

have a comparative idea of the importance of different taxation
measures, public borrowing or deficit financing and other fiscal
measures.

They also help the finance minister in preparing the budget,

particularly in formulating the proposal for a federal government.

They are useful guides for determining the amount of granting, aid
and subsidies to be provided to various units.

70
5. Significance for defense and development:
national income statistics enable the government to make
proper allocation of the national product between defense
[non-productive activity] and development programs
[productive activities] of the economy.

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Its importance
To know economic performance of country
To observe the long run trend of the economy
To formulate economic policies
Comparison with other countries

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The Relationship between Macroeconomic Variables
1. Business Cycle and output Gap

• Inflation, growth, and unemployment are related

through the business cycle.
• The business cycle is the more or less regular pattern of
expansion (recovery) and contraction (recession) in
economic activity around the path of trend growth.
• At a cyclical peak, economic activity is high relative to
trend; and at a cyclical trough, the low point in
economic activity is reached.
• Inflation, growth, and unemployment all have clear
cyclical patterns.

73
Cont.

74
 Cont.
 Output, employment and employment fluctuate across
different phase of the business cycle.
The GDP trend path may increase
A. Increase in the quantity and quality of resources
B. Advancement in technology

Deviations of output from trend are referred to as the

output gap. The output gap measures the gap between
actual output and the output the economy could
produce at full employment given the existing
resources. Full employment output is also called
potential output.

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Cont.
Output gap =potential output –actual output

76
Okun’s Law (Growth and Unemployment)

• A relationship between real growth and changes in

the unemployment rate is known as Okun’s law,
named after its discoverer, Arthur Okun.

• Okun’s law says that the unemployment rate

declines when growth is above the trend rate.

77
Cont.

78
Inflation –Unemployment Dynamics

• The Phillips curve describes the empirical relationship

between inflation and unemployment: the higher the
rate of unemployment, the lower the rate of inflation.

• The curve suggests that less unemployment can always

be attained by incurring more inflation and that the
inflation rate can always be reduced by incurring the
costs of more unemployment.

• In other words the curve suggests there is a trade-off

between inflation and unemployment

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80