CHAPTER TWO

NATIONAL INCOME ACCOUNTING

Complied by Firew K.(MSc.)

  What Is National Income (Output)?
 National income is the monetary expression of the current flow
of net final g&s resulting from the production activities of the
normal residents of a country during the year. Y = C or I
 The national income is also the net value of the contribution of the
factors of production through the production units in the country &
abroad in the year.
 National income is the aggregate factor income (i.e., earning of
labor & capital, etc), w/c arises from the current production of g&s
by the nation’s economy.
 The nation’s economy refers to the factor of production (labor,
capital) supplied by the normal residents of the national territory.
 From the above definitions, the concept of national income has
three types of interpretations:
 National income represents a receipt total,
 National income represents an expenditure total, and
 National income represents a total final value of production.
 Points to note from National income Definition
1stly, national income refers to the income of a country, say, Ethiopia.
2ndly, its measurement refers to a specified period of time, say, a
year.
3rdly, national income includes all types of goods & services, w/c
have an exchange value, counting each one of them only once.
 Generally, two statistical methods are used to avoid

double counting or multiple counting in the calculation

of national income: Final products method, & Value-added
method.
1. Final products method
 We add up the value of final products only. We fist take the
total value of the final consumer & producer goods produced
in the country during the year.
 This is the aggregate value of all the final goods produced in
the country during the year.
 Collective & gov’t services are also to be added to this
aggregate value of the final goods in order to arrive at
the total product of the nation concerned.
2. Value-Added method
 We add the values created at each stage in the
manufacturing of a commodity.
 Then all such values accruing at all processes in the
manufacturing of all commodities are added up together
to arrive at the national income of the country.
 Factors Determining National Income
1.Quantity & Quality of Factors of production. The quantity &
quality of land, labor, climate, rainfall etc., determine the
quantity & quality of agri.al/industrial production, & hence,
the size of national income.
2.The state of technical(Technology) know-how: A country with
a poor technical knowledge cannot have a large-sized national
income, b/c it will not be in a position to make the best possible
use of its resources.
3.Political Stability: It is an essential prerequisite for
maintaining production at the highest level.
 What is National Income Accounting(NIA)?
 National income accounts are the instruments that help us to
measure the national income of the country.
 They help us to measure the level of production in the economy at
some point of time, & explain the immediate causes of the level
of performance.
 Some of the important totals relating to national income accounts:

Gross National Product (GNP)

Gross Domestic Product (GDP)
Net National Product (NNP)
National Income(NI) or
Net National Income at factor cost (NNI at fc)
Personal income (PI)
Disposable personal income (DPI); and
 Basic Concepts of GDP & GNP
 GNP is the nation’s total production of goods & services (for one
year) evaluated in terms of the market prices of g&s produced.
 GNP is the money value of final g&s produced by domestically
owned factors of production within a given period.
 While GDP is the value of all final g&s produced within the
country’s territory within a given period, the factors of production
used might not be domestically owned.
 Note: GDP is a flow concept not a stock concept).
GDP is an attempt to summarize all economic activity over a period
of time in terms of a single number; economy’s total output & of total
 The d/nce b/n GDP & GNP corresponds to the net income earned by
foreigners. When GDP exceeds GNP residents of a given country
are earning less than foreigners are earning in that country.

 That is, GNP can be higher than GDP, less than GDP or equal to GDP
depending on the magnitude of the Net Factor Income(NFI) = factor
income earned by residents less factor income paid for foreigners.

Two Points to Note

 1st, we must take into account the money value of the final g&s
produced in the economy to avoid double or multiple counting.

 2nd, we must take into account the money value of only

currently produced g&s while estimating the GNP of the country.
 Approaches of Measuring National Income (GDP/GNP)
 There are two methods of estimating the national income of a
country. Both the methods lead to the same results. The two
methods are: Expenditure approach & Income approach.
 Expenditure Approach: The GDP can be viewed as the nation’s total
expenditure on g&s produced during the year. Each unit of g&s
produced is matched by an expenditure on that unit of g&s.
 Under the expenditure approach to GDP, the total national
expenditure can be broken down into the ff categories:
 Personal Consumption Expenditure(C): It includes the consumption
expenditure made for both durable goods(motor-cars, radio-sets, etc)
 Gross Domestic Private Investment(I): This item includes private
investment in ‘capital’ or ‘producer goods’, such as, buildings,
machinery, plant, equipment, etc;
 Gov’ts’ Purchases of G&S (G): The gov’ts-central, state & local-
purchase from the market consumer goods, such as, paper,
stationery, cloth, etc, as well as investment goods, such as
machinery, equipment, plant, etc, for their own enterprises.
 Net Export/Net Foreign Demand (): Represent the net expenditure
from abroad on our g&s, w/c provides income for domestic
producers.
 Symbolically:
 Income Approach: The expenditure incurred on purchasing g&s
produced in a country during the year also becomes the income of
the various factors. Group of these factor-incomes are:
 Wages & salaries of the employees(compensation to employees),
 Incomes of non-company business
 Rental incomes of persons
 Corporate profits, & Incomes from Interest
 The 1st category: excludes certain supplements. These supplements are
the contributions, w/c the employers make to social security & other
provident funds or pension funds of the workers.
 The 2nd category: includes the incomes earned by individual
proprietors, parents & self-employed persons.
 The 3rd category: rental income earned on agri.al & non-agri.al property.

 The 4th category: corporate profits earned by business corporations before the pay’t of
corporate profit taxes or the pay’t of dividends. Thus, the corporate profits are equal to
the sum of corporate profit taxes plus dividends plus undistributed corporate profits.
 The 5th category: net interest earned by individuals from sources other than the organs of the
gov’t.
Items Value
 Public transfers ……………………………………………... 300
 Compensation to employees…………………………..…… 1771
 Personal consumption expenditure……………………...…. 1858
 Rental income of persons...………………………………… 34
 Government purchases of goods & service……………..…. 590
 Indirect business tax ………….…………………..……....... 257
 Factor income received from abroad………………………..150
 Capital consumption allowance/depreciation………………. 322
 Value of exports…………………………………………….. 60
 Proprietor’s income…………………………………………. 134
 Corporate tax………………………………………………... 189
 Gross private domestic investment…………………………. 450
 Net interest…………………………………………………. 215
 Value of imports……………………………………………. 36
 Factor income paid for foreigners…………………………... 100
 Private transfers …………………………………………….. 150
 Symbolically:
 Thus,
 Other Accounts: Net Domestic Product () & Net National Product (NNP)

 Net Domestic Product is the net market value of all the final g&s produced in
the domestic territory of a country during a year.
 Net National Product is the net production of g&s produced by citizens of a
country during a year.

 Net National Income at Factor Cost (NNI): It means the sum of all
incomes earned by resource suppliers for their contribution of land, labor,
capital & e/ship during the year’s net production.
 In other words, it shows how much it costs society in terms of economic
resources to produce that net output.
 Sometimes, we simply call it National Income(NI).
 Mathematically: = -Indirect taxes +Subsidies
 This concept is more satisfactory than the concept of GNP & NNP,
b/c it eliminates the element of double counting inherent in those
two concepts.
 It accords with the basic principle of economic theory, that the pay’ts
received by the factor suppliers equal the value of the goods produced.
Further, the components of NI (at factor cost) are very useful in
dealing with certain economic problems.
 Personal Income (PI): It is the sum of all incomes actually received by all
individuals or hhs during a given year . NI (i.e., total income earned
during a year) is d/t from PI (i.e., the income actually received by hhs).
 We know that all, produced products, must necessarily belong to someone,
& hence can be regarded as NI received by the people of the country,
but not all of the value of this product is paid to them as money income.
PI = Net national income – Undivided corporate profit – corporate income
tax- social security contributions + transfer payment
 Disposable Income (DI): The main drawback of PI is that they do not tell us
how much is actually at the disposable of people for their personal
expenditure. For this we use the concept of DI.
 After a good part of personal income is paid to gov’t in the form of personal
taxes (such as income tax, property tax etc.), what remains of PI is called DI.
 Thus, DI
 DI data are useful for studying the purchasing power of the consumers.
 GDP & its imperfection
 GDP measures the market values of all g&s produced in the given
period.
 Although most g&s are valued at their market prices when computing
GDP, some productions are not sold in the marketplace & therefore do
not have market prices.
 If GDP is to include the value of these g&s, we must use an estimate of
their value. Such an estimate is called an imputed value.
• Housing Services &Imputations
• Home productions & >>
• The Underground Economy & >>
 GDP is an imperfect measure of economic activity.
 Nominal GDP Versus Real GDP
Nominal GDP

• Refers to the market value of g&s measured at current prices.

• It increases either b/c prices rise or b/c quantities rise.
• It is not a good measure of economic well-being.

Real GDP
• Refers to the market value of g&s measured using a constant set of
prices/base-year prices.
• It changes only with changes in quantities, not prices.
• B/c the prices are held constant, real GDP varies from year to year
only if the quantities produced vary.
 B/c a society’s ability to provide economic satisfaction for
its members ultimately depends on the quantities of g&s
produced, not on prices, hence RGDP provides a better
measure of economic well-being than NGDP.
The GDP Deflator & the Consumer Price Index
How can we measure price level?
 We can use three indices to measure prices over time: The
GDP Deflator, the Consumer Price Index (CPI) & the
producer price index, among which the GDP deflator & CPI
are widely applicable.
 The GDP Deflator: From NGDP & RGDP we can compute a 3rd
statistic: the GDP deflator. The GDP deflator, also called the
implicit price deflator for GDP, is the ratio of NGDP to RGDP:

 The GDP deflator reflects what’s happening to the overall level of

prices in the economy.
 The definition of the GDP deflator allows us to separate NGDP
into two parts: one part measures quantities (real GDP) & the
other measures prices(). That is,
 Note: NGDP measures the current dollar value of the output of
the economy. RGDP measures output valued at constant(base)
prices.
 The GDP deflator measures the price of output relative to its price
in the base year. That is, the GDP deflator is used to deflate (i.e.,
take inflation out of) NGDP to yield RGDP.
 The Consumer Price Index (CPI): The most commonly used
measure of the level of prices is the consumer price index (CPI).
 Just as GDP turns the quantities of many g&s into a single number
measuring the value of production, the CPI turns the prices of
many g&s into a single index measuring the overall level of
 Thus, the is the cost of basket of g&s relative to the cost of the same
basket in some base year.
 For eg, suppose that the typical consumer buys 5 apples & 2 oranges
every month. Then the basket of goods consists of 5 apples & 2
oranges, & the CPI is:

 In this CPI, 2002 is the base year. The index tells us how much it costs
now to buy 5 apples & 2 oranges relative to how much it cost to buy the
same basket of fruit in 2002.
 Note: The CPI is the most closely watched index of prices, but it is not the
only such index. Another is the producer price index, w/c measures the price
of a typical basket of goods bought by producers rather than consumers.
 The CPI Versus the GDP Deflator
 The GDP deflator & the CPI give somewhat d/t information about what’s
happening to the overall level of prices in the economy. These are:

 The GDP deflator measures the prices of all g&s produced, whereas
the CPI measures the prices of only the g&s bought by consumers.
Thus, an increase in the price of goods bought by firms or the gov’t
will show up in the GDP deflator but not in the CPI.
 The GDP deflator includes only those goods produced domestically.
Imported goods are not part of GDP & do not show up in the GDP
deflator. Hence, an increase in the price of a Toyota made in Japan &
sold in this country affects the CPI, b/c the Toyota is bought by
consumers, but it does not affect the GDP deflator.
 The 3rd d/nce results from the way the two measures aggregate the many
prices in the economy. The CPI assigns fixed weights to the prices of d/t
goods, whereas the GDP deflator assigns changing weights.
 GNP & Welfare: GNP per capita measures the current & the future per
capita welfare. GNP equals (in a closed economy) consumption plus gross
investment. GNP = C + I
 Current welfare is then measured by current consumption, & the change
in future: consumption opportunities caused by current saving –&-
investment decisions is measured by current investments.
 GNP is not a net concept. We are interested in net investment i.e., NNP.
 Conventional net investments do not include changes in most natural
assets, although they are indispensable for human welfare. Consumption
as conventionally measured does not include environmental damage.
 Dasgupta & Maler (1991) & Hartwick (1990, 1992) have tried to
develop a theoretical framework for accounting system. i.e., as follows:

 NNP = Consumption - current environmental damage + Net

investment in real capital + Net change in the value of Human capital
+ Net change in the value of the stock of natural capital

The Business Cycle & the Output Gap

 The business cycle is the more/less regular pattern of expansion &

contraction in economic activity around the path of trend growth.

 At a cyclical peak, economic activity is high relative to trend; & at a

cyclical trough, the low point in economic activity is reached. Inflation,
growth, & unemploy’t all have clear cyclical patterns.
 Over time, real GDP changes for two reasons:
 1st, more resources become available which allows the economy to
produce more g&s, resulting in a rising trend level of output.
 2nd, factors are not fully employed all the time. Thus, output can be
increased by increasing the existing capacity utilization.

 Deviations of output from trend are referred to as the output gap.

 The output gap measures the gap b/n actual output & the output the
economy could produce at full employ’t given the existing resources.
Full employ’t output is also called potential output.

 Okun’s Law shows -ve r/ship b/n real growth & changes in the
unemploy’t rate. Its discovered by Arthur Okun. The law says that
the unemploy’t rate declines when growth is above the trend rate.

 Where is change in unemployment, the magnitude in which

unemploy’t declines due to a percentage point growth, actual growth
Inflation –Unemployment Dynamics: The Phillips Curve

 The Phillips curve describes the empirical r/ship b/n

inflation & unemploy’t: the higher the rate of unemploy’t,
the lower the rate of inflation.

 The curve suggests that less unemployment can always be

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

 In other words, the curve suggests that there is a trade-off

b/n inflation & unemployment.