RIFT VALLEY UNIVERSITY 6 KILO CAMPUS LECTURE NOTES

CHAPTER TWO: National Income Accounting

Introduction: National income accounts are the instruments that help us to measure the
national income of the country. The various types of national income accounts helps us to
measure the level of production in the economy at some point of time, and explain the
immediate causes of the level of performance.

2.1 The Concepts of Gross Domestic Product and Gross National Product
Gross Domestic Product (GDP)

Of the various ways to measure an economy‘s total output, the most popular choice by far is
the gross domestic product, or GDP for short. Gross Domestic Product (GDP) is the market
value of all final goods and services produced within an economy in a given period of time.
The single most important measure of overall economic performance is Gross Domestic Product
(GDP). The GDP is an attempt to summarize all economic activity over a period of time in
terms of a single number; it is a measure of the economy’s total output and of total income. In
other words GDP is the value of all final goods and services produced in the economy in a
given time period (note that GDP is a flow not a stock).
Real GDP versus Nominal GDP
Valuing goods at their market price allows us to add different goods into a composite measure,
but also means we might be misled into thinking we are producing more if prices are rising.
Thus, it is important to correct for changes in prices. To do this, economists value goods at
the prices at which they sold at in some given year. For example, in Ethiopia, we mostly
measure GDP at 1980/81 prices. This is known as real GDP. GDP measured at current prices
is known as nominal GDP.

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GDP and GNP

There is a distinction between GDP and gross national product (GNP). GNP is the value of
final goods and services produced by domestically owned factors of production within a
given period.
GNP is the value of final goods and services produced by domestically owned factors of
production within a given period.
While GDP is the value of final goods and services produced within the country’s
territory within a given period, the factors of production used might not be domestically
owned.
The difference between GDP and GNP corresponds to the net income earned by
foreigners. 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 ofthe world:
 GNP =GDP +Factor Payments from Abroad _Factor Payments to Abroad.
When GDP exceeds GNP residents of a given country are earning less abroad than
foreigners are earning in that country. In Ethiopia, GDP has exceeded GNP since 1981
(based on the data available in World Development Indicators CD-ROM, 2000) but the gap is well
below 1% (0.75% to be exact) during 1981 – 1998.
In simple words, GDP is territorial while GNP is national.
Two points must be kept in mind while calculating the GNP or GDP of a country.
Firstly, we must take in to account the money value of the final goods (and services)
produced in the economy to avoid double or multiple counting. It should be remembered
that final goods and services are those, which are finally consumed by the consumers.
Such goods and services do not enter in to the manufacture of other goods. As against
this, intermediate goods and services are those goods and services, which do enter in to
the production of other goods and services (Bread, for example, is final good, but flour is
an intermediate good). Intermediate products are to be excluding from the GNP.
Secondly, we must take in to account the money value of only currently produced goods
and services while estimating the GNP of the country. This is due to the fact that the
GNP is a measure of the economy’s productivity during a particular period of time.
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2.2 Approaches of measuring national income (GDP/GNP)

There are generally two methods of estimating the GNP/GDP of a country. Both the
methods lead to the same results. The two methods are: Expenditure approach and Income
approach.
A. Expenditure Approach to GNP: The GNP can be viewed as the nation’s total
expenditure on goods and services produced during the year. Under the expenditure approach
to GNP, the total national expenditure can be broken down in to the following categories:
A. Personal Consumption Expenditure (C). It includes the consumption expenditure
made for both durable goods (such as, motor-cars, radio-sets, etc., but not houses) and
non-durable goods (such as, food, drinks, clothing, etc.) produced in the country during
the year. This sub-head also includes expenditure on the purchase of a house is treated
as investment rather than consumption expenditure.
B. Gross Domestic Private Investment (I). This item includes private investment in
‘capital’ or ‘producer goods’, such as, buildings, machinery, plant, equipment, etc;
Business firms primarily purchase such goods. Houses are also included in this category
of expenditure, because they are so durable that they represent, in fact, capital goods.
C. Governments’ Purchases of Goods and Services (G).
The governments-central, state and 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. In addition, the governments also purchase a number
of different services-military, police, secretarial etc. Governments do spend large amounts
of money on what are called transfer payments (e.g., unemployment insurance and social
security payments). Since these payments are not payments for currently produced goods
and services, the amount spent on transfer payments included in the GNP of the country.
D. Net Foreign Investment. As is well known, the entire production of a country is not
sold within the country. A part of it is the GNP of the country. At the same time, the
country imports some finished goods from other countries during the year. To make
proper allowance for such exports and imports, the value of imports should be deducted
from the value of exports. If the balance is positive, it should be added to the other
items of expenditure. If it is negative, it should be subtracted from the sum of the other
expenditure items.
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It is; thus, clear that if the entire production of a country is purchased at market prices, the
amount so spent will represent the GNP of the country. Therefore, to estimate the GNP, we
have to add the above four categories of expenditure.
Illustration
Gross National Product (GNP):
Equals
Personal consumption expenditure (C)
Plus
Gross domestic private investment (I)
Plus
Government purchases of goods and services (G)
Plus
Net foreign Investment (FI)
Symbolically: GNP= C +I + G + FI
We know the difference between GDP and GNP is the net factor income from abroad
(NFIA) which is the difference between Income received from abroad from the citizen of the
country (IRFA), and the income paid to the foreigner (IPTA):
NFIFA= IRFA - IPTA
Gross domestic product, the market value of all final goods and services produced in the
country territory irrespective of citizenship, is the difference between GNP and net factor
income from abroad.
Symbolically: GDP= GNP – NFIFA
As a result the above approach to calculate GNP also works to Calculate GDP. Therefore, we
reach up on
GDP= C +I + G + FI +NFIFA
If there is no net factor income received from abroad:
GDP=GNP= C +I + G + FI
B. Income Approach to GNP. The expenditure incurred on purchasing goods and services
produced in a country during the year also becomes the income of the various factors, which
collaborated in the production of those goods and services. We can group these factor-
incomes in the following categories:
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E. Wages and salaries of the employees (or compensation to employees),

F. Incomes of non-company business
G. Rental incomes of persons
H. Corporate profits, and
I. Incomes from Interest
 The first category, as said above, includes the wages and salaries received by the
employees during the year plus certain supplements. These supplements are the
contributions, which the employers make to social security and other provident funds
or pension funds of the workers.
 The second category includes the incomes earned by individual proprietors, parents
and self-employed persons.
 The third category comprises rental income earned by individuals on agricultural and
non-agricultural property.
 The fourth category includes corporate profits earned by business corporations before
the payment of corporate profit taxes or the payment of dividends to the shareholders.
Thus, the corporate profits, used in calculating the GNP, are equal to the sum of
corporate profit taxes plus dividends paid top the shareholders plus undistributed
corporate profits.
 The fifth category contains net interest earned by individuals from sources other than
the organs of the government.
An aggregate of the above five categories of incomes will not be equal to the GNP as
estimated by the Expenditure Method. The reason is that a part of the total expenditure
incurred by the community does not become available to the other factors of production
in the form of incomes. There are two such leakages.
 First, indirect taxes levied by the government on goods and services; and
 Second, depreciation of machinery, plants and buildings.
The expenditure incurred by the households (factors) on goods and services includes the
indirect taxes levied by the government. The income from these indirect taxes goes to the
government and is not available to the households (factors). Likewise, while calculating the
GNP, we include the depreciation (loss in value suffered by machinery, equipment,
buildings etc.). Like the indirect taxes, the payment on account of depreciation does not
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become available to the households (factors) in the form of income. In other words

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depreciation is no part of the factor incomes. Therefore, while estimating the GNP by the
Income Method, we have to add indirect taxes and depreciation charges to the factor
incomes.
Illustration: GNP in the Income Method can be calculated as follows:

Gross national product (GNP):

Equals
Wages and salaries of employees (W/S)
Plus
Income of non-company business (I)
Plus
Rental incomes of persons (R)
Plus
Corporate profits (Π)
Plus
Income from net interest (r)
Plus
Indirect taxes (IT)
Plus
Depreciation of capital goods (D)
Symbolically: GNP= W/S +I + R + Π + r + IT + D
Therefore, GDP= W/S +I + R + Π + r +IT+ D -NFIFA
Or
GDP= GNP –NFIFA
GDP and GNP are the most frequently used national income concepts. They have their own
merits and demerits.
Merits
 They are better index, than any other concept, of the actual conditions of production
and employment in a country during a specified period.
 They are also statistically simpler concepts, as it takes no account of depreciation and
replacement problems.
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Demerits
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 They are not a net measure of the nation’s economic performance, for they are, as the
term states, a gross measure.
 They don’t include the cost for environmental protection
 Since they are the measure of the market value of all final goods and service they don’t
incorporate the non-market activities i.e., Underground Economy
2.3. Other Social Accounts (NNP, NI, PI and DI)
i. Net National Product (NNP) and Net Domestic Products NDP)
The other important concepts of national income are net national product and net domestic
product. Net national product is defined as the net production of goods and services
produced by citizens of a country during a year and net domestic product is defined as the net
production of goods and services produced in a country territory during a year. To compute:
NNP= GNP – Depreciation
NDP= GDP - Depreciation
ii. Net National Income at Factor Cost (NNI)
National Income at factor cost means the sum of all incomes earned by resource suppliers for
their contribution of land, labour, capital and entrepreneurship during the year’s net
production. In other words, national income at factor cost shows how much it costs society in
terms of economic resources to produce that net output. Sometimes, we simply call it national
income. It is equal to net national product minus indirect tax plus subsidies.
To put it differently:
National income (at Factor Cost)
Equals
Net National Product (NNP=National Income at Market price)
Minus
Indirect Taxes
Plus
Subsidies
NI= NNP-Indirect taxes +Subsidies
iii. Disposable Income (DI)
The main drawback of personal income 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 disposable
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income. After a good part of personal income is paid to government in the form of personal

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taxes (such as income tax, property tax etc.), what remains of personal income is called
Disposable Income. Thus,
Disposable Income (DI) = Personal Income – Personal Taxes
Disposable income data are useful for studying the purchasing power of the consumers.
2.3. Basic Concepts and Methods of Macroeconomic Analysis
The major macro-economic variables are: Output, unemployment, and Inflation.
 Output: Is the production of goods and services or the national income of the
country.
 Unemployment rate: unemployment rate is the percent of the labour force that is
not employed. The unemployment rate measures the fraction of the labour force that
is looking for but cannot find the work.
 Inflation: Is the general increase in the price level
One aspect of economic performance is how well an economy uses its resources. Because
an economy’s workers are its chief resource, keeping workers employed is a dominant
concern of economic policy makers.
Unemployed: A person who is willing to have a job and actively seeking it but couldn’t
find the job.
Employed: A person who have a job and actively participate at a paid job.
Then unemployment rate is the statistic that measures the percentage of those people
wanting to work who do not have jobs.
Numberofunemployed
UnemploymentRate   100
Labourforce

The labour force is defined as the sum of the employed and unemployed, and the
unemployment rate is defined as the percentage of the labour force that is unemployed.
LabourForce  NumberofEmployed  NumberofUnemployed

A related statistics is the Labour-force-participation Rate, the percentage of the adult

population that is in the labour force:
LabourForce
Labour  ForceParticiaptionRate   100
AdultPopulation
Illustration: Spouses the Statistical Authority in Ethiopia have the following result from
the census taken in 1994. The number of unemployed is 45 billion, employed 20 billion and
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adult population 50 billion.

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Find 1) Unemployment Rate

2) Labour-Force Participation rate
Solution: To find the unemployment rate first we need to have the Labour Force;
Labour Force= Unemployed + Employed
= 45 billion + 20 Billion = 65 billion
Then;
Numberofunemployed
UnemploymentRate   100
Labourforce

45billion
UnemploymentRate   100  0.6923%
65billion

Labour-Force participation rate can be also calculated as follows:

LabourForce
Labour  ForceParticiaptionRate   100
AdultPopulation
65billion
Labour  ForceParticiaptionRate   100  1.3%
50billion
The Business Cycle and the Output Gap: Inflation, growth, and unemployment are
related through the business cycle. Market economies experience fluctuations in real GDP
and employment over time. These fluctuations are referred to as the business cycle. Short-
run economic fluctuations are often called business cycles. 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.
Recessions: periods of falling real incomes
and rising unemployment
Depressions: severe recessions (very rare)
A recession is said to occur when real GDP falls (typically economists will only say that a
recession has occurred if real GDP has fallen for two consecutive quarters). An expansion
occurs when output is rising. The peak of the cycle is the point at which an expansion ends
and a recession begins. A recession ends and an expansion begins at the trough of the
business cycle. A very severe recession has, since the experience of the 1930s, been called a
depression. 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
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all have clear cyclical patterns.

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In short, Business cycle shows us the ups and downs of country’s GDP.

2.1. Idealized Business Cycle

Peak

Real GDP per year

Peak

Trough
Recession Recovery
Amplitude

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.
 Second, factors are not fully employed all the time. Thus, increasing capacity
utilization can increase output.
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 recession unemployment increases and less
output are 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
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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.
Because employed workers help to produce goods and services and unemployed workers
do not, increases in the unemployment rate should be associated with decreases in real
GDP. This negative relationship between unemployment and GDP is called Okun’s Law.

Okun’s Law: 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.
u = -x (ya – yt)
Where u is change in unemployment, x the magnitude in which unemployment declines
due to a percentage point growth, ya actual growth rate of output, and yt is trend output
growth rate. The figure below shows the Okun’s law relationship between unemployment
and growth in output.
Growth and Unemployment Dynamics

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Percentage change in real GDP

0
-3 -2 -1 0 1 2 3

-3
Change in unemployment rate

Fig 2.2 Growth and Unemployment Dynamics

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
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curve suggests that less unemployment can always be attained by incurring more inflation
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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.
Fig 2.3 Phillips curve

Case study: The Phillips curve for Ethiopia

Yohannes (2000), attempted to estimate the Phillips curve for Ethiopia by plotting the
actual rate of inflation against the rate of unemployment and conclude that the
higher the unemployment is the higher the inflation is. At least in the short run,
inflation is positively related with unemployment, i.e. there is no tradeoff between
them. The traditional Phillips curve is not therefore applicable to Ethiopia. The
policy implication is that it is not wise for the government to choose high
unemployment in order to dampen inflation and vice versa. If it chooses higher
unemployment it may end up in higher inflation. Since the economy is dominantly
agrarian, characterized by production rigidities and market fragmentation,
government policy to manage the economy from the demand side wouldn’t be
effective. The only solution to fight against inflation is therefore to support the
working of the supply side and remove structural bottlenecks.
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