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Chapter Two

National Income
accounting

How do we know how well the economy is doing?


Economists collect statistics on production,

income, investment, and savings.


This is called national income accounting.
The most important measure of growth is GDP.

What is GDP?
It is the nations expenditure on all the final goods
and services produced during the year at market
prices.
An alternate definition:
GDP is the value of all the final goods and

This would include the wages, rent, interest,

and profits earned by foreigners who work


in the Ethiopia.
We include only those goods and services that

consumers, businesses, and governments buy


for their own use.
What does GDP tell us?
Just like calculating your own income, GDP

measures how well the Ethiopian economy is


doing financially.

Current market prices, reflecting the value society

places on items, are used to aggregate different


outputs to a dollar total.
Government purchases, many of which do not occur

on markets, are valued at their cost of production.


Only final goods and services are included-anything

that is directly sold to the consumer.


Intermediate goods, such as steel that has yet to
be made into hammers and shovels, are not
included. This practice avoids double-counting the
steel.
This measure is an annual flow, a rate of production.

Finally, GDP is a flow variable not a stock.

GDP, being a flow, is not a measure of the total

wealth of a country but a measure of the income


"of the country during a certain period of time.
Ethiopian GDP measures production by Ethiopian

citizens and foreigners alike inside the geographic


borders of Ethiopia and so unequivocally reflects
economic activity in Ethiopia.
Economists and the media use many names besides

GDP to refer to the nation's annual output of goods


and services.
Output, total output, national output, income, total

income, national income, and aggregate supply are


common.

Algebraic representations use the capital letter Y.


These names suggest that economists use the

terminology output and income interchangeably; it


is important to understand why.
The

essence of why output and income are


considered the same thing is that whatever is
spent on a product (the value of that output) is
divided up as income by those people producing it.

Consider one element of GDP, a loaf of bread

worth a dollar.


Some

of the dollar is

profit/proprietor

income to the grocer, baker, miller,


and farmer (or dividend income to their stockholders),

some

is wage and salary income to their employees,

some

is interest income to the banker who has


financed their loans (or interest income to those who
purchased their corporate bonds), and

some

It

is rental income to their landlords.

is because of this equivalence that total output, GDP,


is referred to as total income.

GDP and GNP


GNP is the value of all final goods and services produced

by domestically owned factors of production within a


given period.
The difference between GDP and GNP arise due the fact

that some of the goods and services produced within a


given country is made by factors of production owned by
abroad.
The difference between GDP and GNP correspond to the

net income earned by foreigners.


When GDP exceed GNP, residents of a given country are

earning less abroad than foreigners are earning in that


country.

Income, Expenditure, and the Circular Flow


Imagine an economy that produces a single good, bread, from a

single input, labor.


The inner loop tells us the flow of bread and labor.
The households sell their labor to the firms.
The firms use the labor of their workers to produce bread,

which the firms in turn sell to the households.


The outer loop represents the corresponding flow of birr.
The households buy bread from the firms.
The firms use some of the revenue from these sales to pay

the wages of their workers, and the remainder is the profit


belonging to the owners of the firms (who themselves are
part of the household sector).

GDP measures the flow of birr in this economy.


We can compute it in two ways.
GDP is the total income from the production of

bread, which equals the sum of wages and profit


the top half of the circular flow of birr.
GDP is also the total expenditure on purchases of

breadthe bottom half of the circular flow of birr.


To compute GDP, we can look at either the flow of

birr from firms to households or the flow of birr from


households to firms.
These two ways of computing GDP must be equal

Rules for Computing GDP


Adding different goods and services
Because different products have different values,
GDP

combines the value of these goods and


services into a single measure using market price.

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 economys income.


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

The Treatment of Inventories


Imagine that a bakery hires workers to

produce more bread, pays their wages, and


then fails to sell the additional bread.
How does this transaction affect GDP?

Lets first suppose that the bread


spoils
In this case, the firm has paid more in wages
but has not received any additional revenue,
so the firms profit is reduced by the amount
that wages are increased.

Total income hasnt changed eitheralthough more

is distributed as wages and less as profit.


Because the transaction affects neither expenditure

nor income, it does not alter GDP.


Now suppose, instead, that the bread is put into

inventory to be sold later


In this case, the transaction is treated differently.
The

owners of the firm are assumed to have


purchased the bread for the firms inventory, and
the firms profit is not reduced by the additional
wages it has paid.

Because the higher wages raise total income, and

greater spending on inventory raises


expenditure, the economys GDP rises.

total

What happens later when the firm sells the bread

out of inventory?
This case is much like the sale of a used good.
There is spending by bread 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.

Intermediate Goods and Value Added


To add the intermediate goods to the final goods would be

double counting.
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 firms

output less the value of the intermediate goods that the


firm purchases.
For the economy as a whole, the sum of all value 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.

Housing Services and Other Imputations


Some goods and services are not sold in the marketplace and

therefore do not have market prices.


Thus, we must use an estimate of their value. Such an

estimate is called an imputed value.


Eg.
The estimated value of what the market rent for a house would
be if it were rented and it will be included as part of GDP.
For those government services provided to the general public,

since they are not sold in the market valuation is difficult.


The cost of providing these services will be included as part of

GDP.
In many cases, an imputation is called for in principle but,

to keep things simple, is not made in practice.

It is difficult to incorporate the inputted value of all

goods owned and used by the owner.


Some of the output of the economy is produced and

consumed at home and never enters the marketplace.


Finally, no imputation is made for the value of goods

and services sold in the underground economy.


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.
Because the imputations necessary for computing GDP

are only approximate, and because the value of many


goods and services is left out altogether,

GDP is an imperfect measure of economic activity.

These

imperfections are most problematic when

comparing standards of living across countries.

The size of the underground economy, for instance,

varies from country to country.

Yet as long as the magnitude of these imperfections

remains fairly constant over time, GDP is useful for


comparing economic activity from year to year.

Real GDP Versus Nominal GDP


Is GDP a good measure of economic well-being?
GDP is the value of all final goods and services produced.

Nominal GDP measures these values using current prices.


Real GDP measure these values using the prices of a
base year
Real Vs. Nominal GDP
2005
P
Good
A

2006
Q

Birr 30 900

2007
Q

Birr 31 1000

Compute
GDP
Goodnominal
Birr
192 in each
Birr year.
200
B

100

102

Birr 36 1050
100

205

Compute real GDP in each year using 2005 as the base


year.

Real GDP controls for inflation


Changes in nominal GDP can be due to:
o Changes in prices
o Changes in quantities of output produced

Changes in real GDP can only be due to changes


in quantities, because real GDP is constructed
using constant base-year prices
Because a societys 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.

The GDP Deflator


Inflation rate: the percentage increase in the overall level of
prices
One measure of the price level: GDP deflator
GDP Deflator = 100*(Nominal GDP/Real GDP)
The GDP deflator reflects whats happening to the overall level of

prices in the economy.


NGDP

RGDP

GDP
deflator

Inflation
rate

2005

Birr 46,200

Birr 46,200 ?

n.a

2006

Birr 51,400

Birr 50,00

2007

Birr 58,300

Birr 52,000 ?

Use your previous answers to compute the GDP deflator in each

year.
Use GDP deflator to compute the inflation rate from 2005 to 2006,
and from 2006 to 2007.

Chain-Weighted Real GDP


Over time, relative prices change, so the base

year should be updated periodically.


The chain-weighted real GDP updates the base
year every year, so it is more accurate than
constant-price GDP .
Consumer Price Index (CPI)
A measure of the overall level of prices
Published by the Central Statistics Agency (CSA)
Uses:
o Tracks changes in the typical households cost
of living
o adjusts many contracts for inflation (COLAs)
o allows comparisons of dollar amounts over time

How the CSA constructs the CPI


1. Survey consumers to determine composition of the
typical consumers basket of goods
2. Every month, collect data on prices of all items in
the basket; compute cost of basket
3. CPI in any month equals
100* Cost of basket in that month
Cost of basket in base period

Compute CPI
Basket: 20 pizza, 10 CDs
Prices:
Pizza

CDs

2005

Birr 10

Birr 15

2006

Birr 11

Birr 15

2007

Birr 12

Birr 16

2008

Birr 13

Birr 15

For each year,


compute
the cost of the
basket
the CPI (use
2005as
the base year)
the inflation
rate from
the preceding

Why the CPI may overstate inflation


Substitution bias:
The CPI uses

fixed weights, so it cannot reflect


consumers ability to substitute toward goods whose
relative prices have fallen.

Introduction of new goods:


The introduction of new goods makes consumers better
off and, in effect, increases the real value of the dollar.
But it does not reduce the CPI, because the CPI uses fixed

weights.
Unmeasured changes in quality:
Quality improvements increase the value of the dollar but

are often not fully measured.

CPI vs. GDP Deflator


Prices of capital goods:
included in GDP deflator (if produced domestically)
excluded from CPI

Prices of imported consumer goods:


included in CPI
excluded from GDP deflator

The basket of goods:


CPI: fixed
GDP deflator: changes every year

The expenditure components of GDP


Consumption,

Aggregate
expenditu
re

Investment,

I
Government spending, G
Net exports, NX
An important identity:

Value of total
output

Y=C+I+G
+ NX

Consumption (C)
The value of all goods and services bought by households.
Includes:
o Durable goods : last a long time
e.g., cars, home appliances
o Nondurable goods: last a short time
e.g., food, clothing
o Services: intangible items purchased by consumers
e.g., dry cleaning, air travel

Investment (I)
Spending on capital, a physical asset used in future production .Includes:
o Business fixed investment: Spending on plant and equipment
o Residential fixed investment: Spending by consumers on housing
o Inventory investment: The change in the value of all firms inventories
Government spending (G)
G includes all government spending on goods and services.
G excludes transfer payments (e.g., unemployment insurance
payments), because they do not represent spending on goods and
services.

Net exports (NX)


NX = exports imports

Exports: the value of goods and services


sold to other countries
Imports: the value of goods and services
purchased from other countries
Hence, NX equals net spending from abroad on our goods and services

Other Measures of Income


GNP =GDP +Factor Payments From Abroad Factor

Payments to Abroad.
To obtain net national product (NNP), we subtract the

depreciation of capitalthe amount of the economys


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.


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 a measure called national income:


National Income =NNP Indirect Business Taxes.
National income measures how much everyone in the

economy has earned.


The five categories national income are:-

Compensation of employees :The wages and fringe


benefits earned by workers.
Proprietors income : The income of non corporate
businesses, such as small farms, mom-and-pop stores, 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
foreigners.

Personal

income, the amount of income that


households and non corporate businesses receive.

Personal Income =National

Income

Corporate Profits
Social Insurance Contributions
Net Interest
+Dividends
+Government Transfers to Individuals
+Personal Interest Income.
Next, 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.

The Business Cycle and the 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.
The trend path of GDP is the path GDP would take if factors of

production were fully employed.


Over time, real GDP changes for the two reasons.
First, more resources become available which allows the

economy to produce more goods and services, resulting in a


rising trend level of output.

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 the trend level.
During expansion (or recovery) the employment
of factors of production increased, and that is a
source of increased production.
Conversely, during a recession unemployment
increases and less output is produced than can in
fact be produced with the existing resources and
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.
Output gap potential output actual output
When looking at the business cycle fluctuation, one

question that naturally arises is whether expansions give


way inevitably to old age, or whether they are instead
brought to an end by policy mistakes.
Often a long expansion reduces unemployment too

much; causes inflationary pressures, and therefore


triggers policies to fight inflation- and such policies
usually create recessions.

Okuns Law
A relationship between real growth and changes in the

unemployment rate is known as Okuns law,


Named after its discoverer, Arthur Okun.
Okuns law says that the unemployment rate declines when
growth is above the trend rate.

Inflation Unemployment Dynamics: The


Phillips Curve
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.

The End

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