CHAPTER TWO

NATIONAL INCOME ACCOUNTING

 A large and complex economic system requires some standards

used to measure that performance.

 An understanding of the economic system and its effect on

people’s living condition becomes easy if we have the general
description of the economic activities of a country in the form of
a numerical statement.

 Estimates of national income, expenditures and output give us

such a convenient and concise view of an economic system and
its functional units or sectors.
 .

• National income accounting: is a systematic recording of

the economic performance of a country within a given
period of time (usually one fiscal year).
• It is the measurement of aggregate economic activity of
the nation.
• It is the of goods and services produced in the economy in
a given period of time and expressed in monetary terms,.
• It gives a money measure of the net aggregate of goods
and services produced as a result of the economic
activities of the nation of a country in a given period of
time, usually one fiscal year.
 What are the Importance of the NIA?

• The national income accounts are important for the following

reasons:
1. NIA helps a country to measure the level of total output in the
economy in a given period of time.
2. NIA helps us to observe the long-run trend in an economy
(growth and decline or economic fluctuations).
3. It provides information to formulate economic policies that can
help improve the economic performance of the country.
4. NIA is used to measure and assess the performance of the
economy and the contributions made by the different sectors of
the economy to the entire economy.
5. It help us to compare standards of living of different countries
 2.1 The Concepts and Measurements of National Income

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—a term.
• GDP is the total value of currently produced final goods and
services that are produced with in a country’s border during a
given period of time (usually one fiscal year).
Several features of this definition need to be underscored
i. Market value: the possibility of using money values of
things
 .
a. we can value each good and service at the price at which it was
actually sold.
If we take this approach, the resulting measure is called nominal
GDP or GDP in current
• This seems like a perfectly sensible choice, but it has one serious
drawback as a measure of output:
 Nominal GDP rises when prices rise, even if there is no increase
in actual production.
b. Using an alternative measures that correct for inflation by
valuing goods and services produced in different years at the
same set of prices. We call it real GDP or GDP in constant
dollars.
 .

ii. In a given period of time: GDP for a particular year

includes only goods and services produced within that
year. Sales of items produced in previous years are
explicitly excluded.
iii. Final goods and services: only final goods and services
(are those that are purchased by their ultimate users
(consumers)) count in the GDP.
• GDP excludes sales of intermediate good and service.
Intermediate goods are those goods purchased for resale
or for use in producing another good. if they were
included, we would wind up counting the same outputs
two times - double counting.
 .
iv. Domestic economy: The adjective domestic in the definition of
GDP denotes production within the geographic boundaries of a
given country.
For example, some Ethiopians work abroad, and some of them have
offices or factories in foreign countries. Although all of these foreign
employees of Ethiopian firms produce valuable outputs, none of it is
counted in the GDP of Ethiopia.
On the other hand, quite a lot foreign companies produce goods and
services in Ethiopia. All that activity of foreign firms on our soil does
count in our GDP.
v. Underground economy and non-market transaction: For the
most part, only goods and services that pass through organized
markets is counted in the GDP.
 .

2. Gross National Product (GNP)

• One could alternatively define an economy as
consisting of all production units that belong to a
country (whether or not these production units
reside in the country or not).
• The value of production defined in this way for an
economy is called the Gross National Product (GNP).
• It is defined as the value of all final goods and
services produced by citizens of a country during a
specific period, usually one year, irrespective of their
place of residence.
 .

• For example: For Ethiopians working abroad their

income is included in the GNP of Ethiopia and
income earned by foreigners in Ethiopian economy
is included in the GNP of their respective countries.
• GNP=GDP+NFI from abroad
2.2 Approaches of Measuring National Income (GDP)
There are three alternative approaches (methods) for
measuring total output and all three approaches give
identical, namely:
i. Expenditure Approach
ii. Value Added or Output Approach
iii. Income Approach
 1. The Expenditure Approach

• Expenditure approach-involves only counting the value of those

transactions where a commodity reaches its final destination.
• All final goods produced in an economy are purchased either by
the three domestic sectors: households, government and business
enterprises; or by foreign nations.
Hence, measuring total output by the expenditure method involves
breaking down total spending on all goods and services produced into
four categories:
• i. Expenditures by consumers on goods and services (abbreviated
simply to the letter, C);
• ii. Expenditures by business firms on capital goods (Gross/ total
investment spending, I);
• iii. Expenditure by government on goods and services, G); and
• iv. Net exports (the total value of exports minus the total value of
imports, X-M).
• Y=C+I+G+NX. This equation is called the national income accounts
.

identity.
A. Consumption (C)
• Consumption spending is the total of all outlays made by
households on final goods and services.
• In all countries it is by far the largest component of total spending.
• It is divided into three subcategories: nondurable goods, durable
goods, and personal services
Nondurable goods are goods that last only a short time, such as food
and clothing.
b. Durable goods are goods that last a long time, such as cars and TVs.
c. Services include the work done for consumers by individuals and
firms, such as legal advice, haircut, doctor visit, and dental care.
a.
 Investment (I)
.Investment is the production of goods that are not for immediate consumption(i.e
goods bought for future use).
• The total investment in an economy is called gross Investment divided in to
Three
i. Expenditure on capital goods (Business fixed investment): purchases of new plant
and equipment either to replace existing capacity that is wearing out or to
increase capacity. This is often called fixed capital formation.
ii. Residential investment: is the purchase of new housing by households and
landlords for residential purpose. But we do not add trade of existing houses
where change of ownership is made.
iii. Inventories investment: Businesses often choose to maintain inventories for
convenience or necessity, viewing it as a voluntary investment. Uncertain
business conditions can also lead to firms holding stocks due to demand
miscalculations. In both scenarios, accumulating inventories is seen as a form of
investment for businesses.
 C. Government Expenditure on Goods and Services (G)
• All governments, federal, regional and local governments, payments
to factors of production in return for factor services rendered are
counted as part of the GDP.
• Government Expenditure on Goods and Services (G) are the
purchase of goods and services bought by federal, state, and local
governments.
• What is counted is government spending on goods and services,
many of which are bought by the government on behalf of the
public and which are ultimately "consumed" by households:
example education, health care services, national defense, roads,
water and sewage systems, postal services.
• Government expenditure on goods and services is that such
spending is often done on things like highways which are
capable of being used to assist in the production of other goods.
 D. Net Exports (X-M)

• The External Sector Exports (X) represents an addition

to domestic expenditure and must be added to it in
order to arrive at an indication of aggregate demand or
aggregate expenditure. Imports (M) are a subtraction
from domestic expenditure.
• Summing these four expenditure components, C+I+G+
(X-M), gives a single figure, the total amount of
spending done in the economy during the accounting
period.
• GDP = Y = C+I+G+(X-M)
 Numerical Examples

1. We can use a simple farming economy to

understand how the national accounts work.
Suppose that out of the total amount 4700
imported, 8100 are consumed (in C), 1500 go for
government purchases to feed the army (as G), and
5600 go into domestic investment as increases in
inventories (I). In addition, 2000 are exported.
•What, are amount of GDP of this agrarian
economy?
 .

2. Suppose the following describes the economy (all figures in

billions)
Personal Consumption Expenditure
(C) .....................3658.10
Gross Private Domestic Expenditure (I)........................ 745
Government Purchases of Goods & Services (G)......... 1098
Export........................................................................... 670
Import........................................................................... 708
• What is the value of GDP?
GDP = C + I + G + NX
GDP = 3658.10 + 745 + 1098 + (670-708)
GDP = 5463.10
 2. Income Approach
• The income approach measures the GDP in terms of
incomes earned.
• Income approach involves calculation of GDP by
summing up all incomes that derived from the
production process.
• In other words, it includes all payments made in respect
of the four factors of production, namely labor, capital,
land and entrepreneurship over a given period of time.
• This implies that the total of all wages and salaries,
interest, rent and profits is conceptually equal to the
GDP
• Using this approach the national income accounts divide incomes
into five categories: compensation of employees, rental income,
proprietors‘ income, net interest, and corporate profits.
a. Compensation of employee
.

• It is the payments that made by employers for labor services.

• These payments are include Wages, salaries, and supplementary
labor income which referring to employee benefits such as
pensions, workers‘ compensation benefits, and employer
contributions to unemployment insurance funds or other worker
social security schemes.
b.Rental income is the income that received for owning property by
property owners. It includes rent payments received by landlords,
royalty payments from patents and copy rights as well as imputed
rent that homeowners ―pay to themselves.
c. Similarly, the household receive interest income for exchange in
capital. The net interest is the interest that the domestic businesses
pay minus the interest they receive.
d. Profit is a residual left after paying for rent, interest on debt, and
employees‘ compensations and other costs. There are two kinds of
profits in national income accounts: earning of incorporated enterprises
(proprietors‘ income) and profit of corporation (corporate profit).
• d1. Proprietors‘ income consists of earning of partnership and single
owned business firms or earning of incorporated businesses in general.
• d2. corporate profit is the income of corporations after payments of
wage to their workers and creditors. It includes corporate profit taxes,
dividends, and undistributed corporate profits; the latter is what
corporations retained in to business and is called ‘net corporate saving‘
or Retained Earning.
• Two adjustments must be made to get GDP at market
prices:
a. Indirect taxes minus subsidies are added to get from factor
cost to market prices.
b. Depreciation (or capital consumption allowance) is
added to get from net domestic product to gross
domestic product.
GDP at market price Net domestic product/income at factor cost+
Depreciation +Indirect business tax-
Subsidy

OR

GDP at market price Compensation of employees +

Rental income of persons +
Net interest+
Proprietor‘s income
Corporate profits +
Deprecation +
Indirect business taxes (IBT)-
subsidy
Numerical examples
1. Suppose the following describes the economy (all figures in billions)
• Compensation of employees................................................. 3244.20
• Proprietor‘s income.................................................................. 402.40
• Rental income of persons......................................................... 6.70
• Corporate profits ......................................................................297.10
• Net interest.............................................................................. 467.10
• Deprecation.............................................................................. 575.70
• Indirect business taxes (IBT).................................................... 469.90
a. What is the value of net domestic product/income at factor cost?
b. What is the value of GDP at market price?
• Solution:
a. Net domestic product(income at factor cost) =
compensation of employees + rental income +
proprietors‘ income + net interest + corporate profits
= 3244.20 + 6.70 + 402.40 + 467.10 + 297.10
= 4417.50
b. GDP at market price = net GDP at factor cost + indirect
business taxes + Deprecation
= 4417.50 + 575.70 + 469.90 = 5463.10
2. Suppose the following describes the economy (all figures in billions)
• Transfer Payments...................................................................... $54
• Interest Income (i)....................................................................... $150
• Depreciation ................................................................................$36
• Wages (W)................................................................................... $67
• Gross Private Investment............................................................ $124
• Business Profits (PR)................................................................. $200
• Indirect Business Taxes............................................................... $74
• Rental Income (R)....................................................................... $75
• Net Exports................................................................................ $18
• Net Foreign Factor Income........................................................ $12
• Government Purchases.............................................................. $156
• Household Consumption........................................................... $304
a. Find GDP using expenditure approach
b. Find GDP using income approach
c. Compare the GDP values obtained using income and
expenditure approaches.
• Solution:
a. GDP using expenditure approach
• GDP = Household consumption + Gross private
investment + government purchases + net exports
GDP = 304 + 124 +156 + 18 = 602
b. GDP using income approach
• GDP = wages + rental income + interest income +
business profit + indirect business taxes + depreciation
= 67 + 75 + 150 + 200 + 74 + 36
= 602
c. Both approaches yield the same level of GDP.
 3. Output or the Value Added Approach

• A third method is called the "value added method" because it

simply sums the net value (value added) of the output
produced by all firms in the economy.
• Value added is the increase in the market value of the product
that takes place at each stage of the production process.
• There are many interactions among firms in a modern
economy. Many produced goods are sold not to final users as
consumer goods, but to other firms. In the total product
approach the values of each economic sector can be added at
each stages of production.
 Stage of production Sales value Value added

Firm A: Wheat 350 350

Firm B: Flour mill 380 30

Firm C: Bakery 420 40

Firm D: Bread whole seller 470 50

Firm E: Bread Retail Seller 550 80

Total value added (Total 550

income)
2.3.Other Social Accounts
The national income accounts include other measures of income that
differs slightly in definition from GDP.
A) 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 Payments from abroad −Factor Payments to

abroad
B) Toobtain 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.
C) The next adjustment in the national income(NI).
National income measures how much everyone (Ethiopian-owned
resources) in the economy has earned(got money by working).
National Income =NNP −Indirect Business Taxes.
• Indirect business taxes, such as sales(VAT), excise and property
taxes. These taxes place a wedge between the price that consumers
pay for a good and the price that firms receive.

• Once we subtract indirect business taxes from NNP, to obtain a

national income because firms never receive this tax wedge, it is not
part of their income.
D) Personal Income = National Income
− Corporate Profits
+ Dividends
+ Government Transfers to Individuals
− Social Insurance Contributions
+ Personal Interest Income
− Net Interest
NB: Corporate Profits= equals the sum of corporate taxes,
dividends, and retained earnings) and adding back dividends.
• Corporate Profits to be subtracted from National income =
corporate taxes + retained earnings(Undistributed corporate
profit)
E) Disposable personal income is the income individuals
have to spend or save after payment of taxes.
• Disposable personal income =Personal Income −Personal
Tax and Nontax Payments.
No. Expenditure Million USD

1 Gross National Product 7000

2 ( - ) Depreciation -862

3 = Net National product =6138

4 ( - ) Indirect Business taxes (IBT) -796

5 = National Income (NI) =5342

6 (-) Undistributed corporate profits(RE) -29

(-) Corporate income taxes -134
7 (+) Gov. transfer payments to persons +694
(-)Social insurance contribution -0
8 (+) Gov. interest to persons= +203

(Personal interest income - net interest)

9 Personal income = 6076

10 personal taxes -1206

11 = Disposal Personal Income (DPI) = 5956

 2.4.Nominal versus Real GDP

• Nominal GDP represents the market value of all final

goods and services measured in the price of that
period (current prices).
• Since GDP equals the sum of Pi Qi the change in
either the quantity of output or the level of prices
will affect the size of GDP.
• But the value of different years’ GDPs can be usefully
compared only if the value of money (price) itself
doesn’t change as Inflation (or deflation)
complicates the calculation of GDP.
• Rather than price it is the quantity of goods &
services produced &distributed to households which
affects their standard of living, not the price.
• If, for instance, all prices doubled without any change
in quantities, GDP would double.
• This would be misleading to say that the economy’s
ability to satisfy demands of the people has doubled,
because the quantity of every good produced
remains the same.
• Real GDP may be calculated using:
a. Base year fixed prices
• The countries could have their own base year prices.
• In Ethiopia, MOFED has changed the base year for
estimation of real GDP to the year 2010/2011 (2003
Ethiopian Financial year).
b. Chain-weighted measures of GDP
• The base year changes continuously over time.
Numerical example 1:
• Let us take one example a hypothetical country produces
only three products that are teff, soft drink, machinery.
The amount of production and the price of two years are
presented in the following table.
Production 2010/11 2011/12

Price Quantity Price Quantity

Teff 1000 100 1200 100

soft drink 7 75 8 75

Machinery 2000 25 2500 25

i. Nominal GDP for 2010/11 year
• Nominal GDP (in 2010/11) = (price of teff (in
2010/11)* quantity teff (in 2010/11)) + (price
soft drink (in 2010/11) * quantity of soft
drink(in 2010/11)) + (price of machinery(in
2010/11) * quantity of machinery(in 2010/11))
• Nominal GDP (in 2010/11) = (1000) (100) + (7)
(75) + (2000) (25)
=150,525
ii. Similarly, Nominal GDP for 2011/12 year
• Nominal GDP (in 2011/12) = (price of teff (in
2011/12)* quantity teff (in 2011/12)) + (price soft
drink (in 2011/12) * quantity of soft
drink(in2011/12)) + (price of machinery(2011/12)
* quantity of machinery(in 2011/12))
• Nominal GDP (in 2011/12) = (1200) (100) + (8)
(75) + (2500) (25)
=183,100
• If we make comparisons of the GDP of 2010/11 with
2011/12, the GDP grew at 21.64 percent.
Nominal GDP(2011/12)-Nominal GDP(2010/11)
Growth rate of GDP= *100%
Nominal GDP(2010/11)
183,100-150,525
Growth rate of GDP= *100% 21.64
150,525

• But if we observe the level of output of three items, are

equals as before. It clearly indicates that using nominal
GDP for comparative analysis is misleading.
• Applying a certain constant price in different time horizon solves the
problems.
• Using the price of 2010/11as base year computing the Real GDP of two
years, the Real GDP of 2010/11 and of 2011/12 would be identical.
i. Real GDP for 2010/11 year
• Real GDP (in 2010/11) = (price of teff (in 2010/11)* quantity teff (in
2010/11)) + (price soft drink (in 2010/11) * quantity of soft drink(in
2010/11)) + (price of machinery(in 2010/11) * quantity of machinery(in
2010/11))
• Real GDP (in 2010/11) = (1000) (100) + (7) (75) + (2000) (25)
= 150,525
• At base year Nominal and Real GDP are Equal.
ii. Similarly, Real GDP for 2011/12 year
• Real GDP (in 2011/12) = (price of teff (in 2010/11)* quantity teff (in
2011/12)) + (price soft drink (in 2010/11) * quantity of soft drink(in
2011/12)) + (price of machinery(in 2010/11) * quantity of
machinery(in 2011/12))
• Real GDP (2010/11) = (1000) (100) + (7) (75) + (2000) (25)
= 150,525
• Now, if we make comparisons of the GDP of 2010/11 with 2011/12,
the GDP grew at 0 percent, which is technically true.
• Thus, real GDP is comparatively appropriate measure the rate of
economic growth relative to nominal GDP.
 2.5.The GDP Deflator and the Consumer Price Index

2.5.1.GDP Deflator
• From nominal GDP and real GDP we can compute a third
statistic: the GDP deflator.
• The GDP deflator, also called the implicit price deflator
for GDP, is defined as the ratio of nominal GDP to real
GDP.

• GDP Deflator measures the current price of output

relative to its price in the base year.
• Numerical Example:
1. To make the idea more clear let consider the previous
example of a hypothetical country producing only teff,
soft drink, and machinery.
Years Nominal GDP Real GDP

2010/11 150,525 150,525

2011/12 183,100 150,525

 Nominal GDP(2010/11)
GDP Deflator(2010/11)=
Real GDP(2010/11)
150,525
GDP Deflator(2010/11)= 1
150,525

This result implies that at the base year, both nominal and Real GDP
are equal and the GDP Deflator always equal to 1 (or 100 in terms of
percentage).
• Similarly, for the year 2011/12 the GDP Deflator
computed as:
Nominal GDP(2011/12)
GDP Deflator(2011/12)=
Real GDP(2011/12)

183,100
GDP Deflator(2011/12)= 1.2164
150,525

• This result implies that the price in 2011/12 is

21.64 percent relatively higher than that of
2010/11.
• The GDP deflator result is used to measure
inflation rate.
GDP deflator (2011/11)-GDP deflator (2010/11)
Infilation rate= *100%
GDP deflator (2010/11)

1.2164-1
Infilation rate= *100% 0.2164*100% 21.64%
1.2164
• The GDP Deflator has three purpose:
i. It serve as implicit measure of inflation
GDP deflator(t) -GDP deflator (t-1)
Infilation rate(at time t) = *100%
GDP deflator (t-1)

ii. The GDP deflator allows us to separate nominal GDP into

two parts: one part measures quantities (real GDP) and
the other measures prices (the GDP deflator).
• Nominal GDP = Real GDP × GDP Deflator
iii. Help us to deflate nominal GDP to yield real GDP (how
the deflator earns its name: it is used to deflate (that is,
take inflation out of) nominal GDP to yield real GDP.
Nominal GDP
Real GDP=
GDP deflator
2.5.2.Consumer Price Index
• Measures the combined price of a particular collection of
goods and services purchased by the consumer in a
specific period relative to the combined price of an
identical group of goods and services in a given reference
period.
• It begins by collecting the prices of thousands of goods
and services and contains basically all the goods and
services consumed in a country like food, gas, haircuts,
transportation, house rent and so on.
• Just as GDP turns the quantities of many goods and
services into a single number measuring the value of
production, the CPI turns the prices of many goods
and services into a single index measuring the overall
level of prices of goods consumed.
• CPI measures the price of a representative basket
called CPI-basket of goods that purchased by
consumers.
• It is used to compare what a fixed basket of goods
costs this month with what it cost in some reference
base period.
 Cost of market basket of goods at current prices
CPI= *100%
Cost of the same basket of goods at base year prices

Note that CPI = 100 for the selected base year

• In Ethiopia,
 Central Statistical Authority (CSA) has a job of
computing the CPI.
 The CSA calculate and report once a month.
 the CSA determines the market basket that used for
CPI calculation from periodic Consumer Expenditure
Surveys,
 Reference period: 2010/11 (2003 E.C.)
• The CPI calculation has three steps:
i. Finding the cost of CPI-basket at the base period prices.
ii. Finding the cost of CPI-basket at current period prices.
iii. Calculating the CPI for the base period and the current
period.
• Let we use the pervious example to discuss how to
compute the CPI.
Item Quantity Base-year price Subsequent-year price
(2010/11) (2011/12)
Teff 100 1000 1200

Soft drink 75 7 8

Machiney 25 2000 2500

(a) The cost of CPI-basket at base period prices:
2010/11
CPI market basket Cost of CPI
Item Quantity Base-year price market basket
(2010/11)

Teff 100 1000 100,000

Soft drink 75 7 525

Machiney 25 2000 50.000

Cost of CPI-basket at base year prices( in 2010/11) 150,525

 (b) The cost of CPI-basket at a current period prices: 2011/12

(b) The cost of CPI-basket at a current period

prices: 2011/12
CPI market basket Cost of CPI
Item Quantity current price market basket
(2011/12)

Teff 100 1200 120,000

Soft drink 75 8 600

Machiney 25 2500 62,500

Cost of CPI-basket at current year prices( in 2011/12) 183,100

(c) The CPI for the base period and current
period.
Cost of CPI basket of goods at current prices
CPI= *100%
Cost of CPI basket of goods at base year prices

• For 2010/11, the CPI is: (150,525/150,525) (100%) =

100%
• For 2011/12, the CPI is: (183,100/150,525) (100%) =
121.64%
• Inflation rate over a period of time can be
computed using the CPI as follows.
CPIt  CPI t  1
Infilationrate()  *100%
CPIt  1

1.2164  1
 *100%
1

21.64%
The CPI differs from the GDP deflator in three main ways:
i.The first difference is that the GDP deflator measures the prices
of all goods and services produced, whereas the CPI measures
the prices of only the goods and services bought by consumers.
ii. The second difference is that the GDP deflator includes only
those goods produced domestically. Imported goods are not
part of GDP and do not show up in the GDP deflator. Hence, an
increase in the price of a Toyota made in Japan and sold in this
country affects the CPI, because the Toyota is bought by
consumers, but it does not affect the GDP deflator.
iii. The CPI measures the cost of a given basket of goods
and services, which is the same from year to year. The
basket of goods and services included in the GDP
deflator, however, differs from year to year, depending
on what is produced in the economy in each year. In
other words, the CPI assigns fixed weights to the
different goods, whereas the GDP deflator assigns
changing weights.
 2.6.GDP and Welfare

• GDP is a reasonably accurate and extremely useful measure

of national economic performance. It is not, and was never
intended to be, an index of social welfare. There are
important items affecting our wellbeing that are not included
in GDP.
i. Pure financial transactions are excluded: Government
transfers payments (social security or cash welfare benefits),
private transfer payments (student allowances or alimony
payments), and the sale of stocks and bonds are excluded
because they represent transfer of existing assets.
ii. Household services (house cleaning, childcare, meal
preparation, home repair maintenance) are excluded.
iii. Illegal and underground economic activities are not included
in GDP, because these activities are not reported.
Iv. Leisure time is not included in GDP.
v. Volunteer work.
vi. The quality, composition and distribution of output
vii. Cost of environmental damage: The costs of environmental
damage are not subtracted from the market value of final
products when GDP is calculated.
viii. GDP accounting ignores the depletion of natural resources.