CHAPTER TWO

2.0 NATIONAL INCOME ACCOUNTING

The aggregate performance of 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.
Unfortunately, our systems of national income accounting measures are imperfect and provide
only rough guidelines, rather than clear measurements of the economic performance of large
systems because the imputations necessary for computing this measures (like GDP/GNP) are
only approximate, and the value of many goods and services is left out altogether.
As imperfect as the national income accounting methods are, they are the best measures we have
and they do provide substantial useful information.
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 flow 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.
The Importance of the National Income Accounts
The national income accounts are important for the following reasons:
1. The National Income Account helps a country to measure the level of total output in the
economy in a given period of time.
2. National Income Account helps us to observe the long-run trend in an economy (growth and
decline or economic fluctuations).
3. The National Income Account provides information to formulate economic policies that can
help improve the economic performance of the country.

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4. National Income Account 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. National Income Accounts give a clear picture of the state of affairs in the economy. They
consolidate large masses of unorganized data, give continuous information about the economy
and can utilized to improve the results.
6. The National Income Accounts can suggest measures for economic welfare, reducing income
inequalities, cutting down wastages of resources and minimizing costs in the economy. It help us
to compare standards of living of different countries.
2.1 The Concepts and Measurements of National Income
1. 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 you have probably encountered in the news
media.
 Gross domestic product (GDP): is the market value of all final goods and services
produced within an economy in a given period of time.
 It is the most comprehensive measure of the output of all the factories, offices, and shops
of a given country in a given period of time.
 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 terms of this definition need to be underscored.
i. Market value: the possibility of using money values of things
The GDP consists of a combination of variety of goods and services: computer chips and potato
chips, tanks and textbooks, and so on. How can we combine all of these into a single number? To
an economist, there is a natural way to do so: First, convert every good and service into money
terms, and then add all the money up.
Thus, we can add apples and oranges together. To add 10 apples and 20 oranges, first ask: How
much money does each cost? If apples cost 20 cents and oranges cost 25 cents, then the apples
count for $2 and the oranges for $5, so the sum is $7 worth of ―output.
The market price of each good or service is used as an indicator of its value to society because
someone is willing to pay that much money for it. This decision raises the question of which
prices to use in valuing different outputs. We have two choices on this regard.

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a. Most obviously, 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 prices.
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. For this reason, we have devised 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. The
same is true of houses. For example; the resale values of houses do not count in GDP because
they were counted in the years they were built.
iii. Final goods and services: Next, you will note from the definition of gross domestic product
that only final goods and services (are those that are purchased by their ultimate users
(consumers)) count in the GDP. The adjective final is the key word here.
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.
For example, suppose that a loaf of bread (a final good) is produced with flour (an intermediate
good). It would not make sense to add the value of flour separately in the calculation of GDP
since the flour has been consumed‘ in process of making bread and since the market price of
bread already reflects the value of the flour that was used in its production.
Thus, The concept is straightforward, but the measurement problems can be complex. For
example, a given product, say, sugar, can be used as a final product or as input into further
production processes. Thus, this requires a mechanism for distinguishing between the sugar
bought for household consumption and the sugar purchased for further production.
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. (It is counted, instead, in the GDP's of the other countries.) On the other hand, quite

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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. This restriction, of course,
excludes many economic activities. For example, illegal activities are not included in the GDP.
This reflects the inability to measure the value of many of the economy‘s most important
activities, such as housework, repairs, and others. These activities certainly result in currently
produced goods or services, but they all lack that important measuring rod—a market price.
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.
 It refers to that part of the GDP that is actually produced and earned by or transferred to
resident nationals of that country.
 It measures output produced by the labor and property of citizens, regardless of where the
labor and property are located. On contrary, earnings of foreigners which arise out of
their domestic economic activities are thus excluded.
Forexample: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
 Where there is substantial foreign participation in the economy and a large part of total
domestic income is earned and repatriated by foreigners and foreign companies as in
many LDCs, GDP will be much larger than GNP. As a result statistics of GDP growth
may give a false impression of the economic performance of a particular developing
nation.
Gross National Product (GNP): is the total value of goods and services currently produced by
domestically owned factors of production plus/minus net factor income from broad/net factor
payment to abroad in a given period of time.
 GNP=GDP+NFI from abroad or GNP=GDP- NFP to abroad

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2.2 Approaches of Measuring National Income (GDP)
The national income estimates provide not only a single figure showing the national income, but
also supply the detailed figure with regard to the various components of the national income. It is
both the figure of national income and the details regarding its constituents that throw light on
the functioning and performance of the economy.
There are three alternative approaches (methods) for measuring total output, namely:
i. Expenditure Approach
ii. Income Approach
iii. Value Added or Output Approach

Each approach gives a different perspective on the economy. However, the fundamental
principle underlying national income accounting is that, except for problems such as incomplete
or misreported data, all three approaches give identical measurements of the amount of current
economic activity.
i. The Expenditure Approach
The market for consumer goods is by implication the market where final goods and services are sold.
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.
GDP is the sum of the aggregate expenditure on all-final goods and services produced in a given year.
Thus, to determine GDP through this approach, one must add up all types of spending on finished goods
and services by these sectors. 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 (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).
Because all spending done in the country falls into one or other of these four categories, we can
say that total expenditure is the sum of C + I + G + (X-M) i.e Y=C+I+G+NX. 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.
We now examine each of these four main components of total spending.

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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
a. 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.
B. Investment (I)
Investment is the production of goods that are not for immediate consumption(i.e goods bought for
future use). These goods are called investment goods (inventories and capital goods including
residential housing). The total investment in an economy is called gross Investment. Total or
gross investment expenditure may be divided into three main categories:
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. We do, however, count the value of the estate agents commission in the sale of existing
houses as part of GDP. The estate agent provides a current service in bringing buyer and seller
together, and that is appropriately part of current output.
iii. Expenditure on inventories: Many businesses find it convenient or necessary to hold certain
supplies of goods on hand, in which case investment in inventories may be considered voluntary.
Moreover, business conditions are uncertain and so firms may also find themselves holding
stocks because they miscalculated demand. In either case, firms are considered to be investing
when they accumulate inventories.
Treatment of inventories depends on if the goods are safely stored or if they spoil. 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?

The answer depends on what happens to the unsold bread. Let’s first suppose that the bread
spoils. In this case, the firm has paid more in wages but has not received any additional revenue,

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so the firm’s profit is reduced by the amount that wages are increased. Total expenditure in the
economy hasn’t changed because no one buys the bread. Total income hasn’t changed either—
although 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 firm’s inventory, and the firm’s profit is not reduced by the additional wages it has
paid. Because the higher wages raise total income, and greater spending on inventory raises total
expenditure, the economy’s GDP rises.

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.

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. 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.

Gross investment, then, is the total amount of (usually private) spending during the accounting
period on capital goods (defined as structures, machinery and equipment, and inventories).
Because capital by its nature consists of things that are used in the production of other goods and
services, it is inevitable that gross investment includes depreciation. Depreciation is a reduction
in the value of capital goods over time due to their use in production. It is the wearing and
tearing out of capital goods. or and capital consumption allowance is the estimated value of
depreciation plus the value of accidental damage to capital stock. However, the value of
accidental damage is relatively small, so it is common to use the term capital consumption
allowance as depreciation.

Gross Investment – Depreciation =Net Investment.

If the concern is with the long-term growth of the economy, net investment (total investment
during the accounting period minus depreciation) is the important concept because it measures

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the growth of the economy‘s capital stock over time. But if the purpose is to understand short
term, annual fluctuations in the level of total spending it is better to work with gross investment.
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:
education, health care services, national defense, roads, water and sewage systems, postal
services.
Much of the spending done by governments in the developed countries today takes the form of
simple transfers of income from taxpayers to those eligible for the wide range of income
supplements available to assist the elderly, the sick and the unemployed, because such transfer
payments reallocate existing income and are not made in exchange for goods and services, they
are not part of GDP. The same holds true for interest payment on the government debt. Interest is
treated as a payment for debt incurred to pay for past wars or government programs and is not
considered to be a purchase of a current good or service. Government interest payments are
considered as transfers and therefore omitted from GDP
Thus, if you receive a wage from the government because you are a teacher, your wage is a
factor payment and would be included in GDP. If you receive a welfare payment because you are
poor, the payment is not in return for service but is a transfer payment and would be excluded
from GDP..
Thus, do not confuse the way the national accounts measure government spending on goods and
services (G) with the official government budget. When the Treasury measures its expenditures,
it includes purchase of goods and services (G) plus Transfers.
There are two complications concerning government expenditures:
i. Because so many of these goods and services are provided "free" or in other ways that bypass
markets, it is difficult to determine their value in the same way that the value of the other items
entering into C would be determined. Consequently, national income accountants value

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government spending on the basis of what the government pays for the goods and services it
requires- based on imputed value at cost of providing services.
For example, police officers, firefighters, and city mayor 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.
ii. 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.
Logically, such spending should be thought of as investment spending. Some countries produce
their accounts in such a form that government spending can be separated into two categories,
current spending on goods and services, and investment spending.
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. An increase in imports (M) lowers
aggregate demand and hence employment whereas a rise in exports (X) has the opposite effect.
For example, production differs from sales in Ethiopia in two respects. First, some of our
production (coffee and oil seeds) is bought by foreigners and shipped abroad, and these items
constitute our exports. Second, some of what we consume (Arabian oil and Indian car) is
produced abroad and shipped to Ethiopia, and such items are Ethiopian Imports. A significant
part of total spending in most countries goes toward the purchase of goods produced abroad
rather than domestically, such outlays represent spending which leaks from the domestic
economy to the rest of the world and is consequently treated as a negative entry in measures of
total domestic spending. But it is offset to a greater or lesser degree by the spending of non-
residents on goods produced and exported to international markets. It is often convenient,
therefore, to take domestic spending on imports and foreign spending on exports as a combined
value, usually called net exports, a value which may be positive or negative in any accounting
period depending on which component, exports or imports, is larger.
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.

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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 produced and 7 imported, 87 quintals are consumed (in C),
10 go for government purchases to feed the army (as G), and 6 go into domestic investment as
increases in inventories (I). In addition, 4 quintals are exported.
What, then, is the composition and amount of GDP of this agrarian economy?
GDP= 87 of C + 6 of I + 10 of G + (4 of X – 7 of M)
GDP=100 quintals
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
3. Suppose the following describes the economy (all figures in billions)
GDP......................................................................................... 9000 birr
Investment............................................................. 1500
Consumption.......................................................... 5000
Government purchases of goods and services......... 1000
What is the value of net export?
GDP= C + I + G + NX
9000 = 5000 + 1500 + 1000 + NX
NX = 9000- 7500
NX = 1500 birr
2. Income Approach

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The income approach measures the GNP 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 as calculated
according to the production method.
In principle output expressed in monetary terms must be equal to the total monetary income
deriving from it (i.e. value of final goods and services = Total income). 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 is the most important and certainly the simplest factor costs to
measure. 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 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.‘
The sum of these five income components gives as the net domestic income at factor cost. But if
this figure for factor costs or income is compared with the total arrived by the expenditure
method. it falls considerably short of the amount expected. The reason is that a part of the total

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expenditure incurred by the community does not become available to the other factors of
production in the form of incomes. Thus, 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.
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). In order to estimate GDP at market price it is
therefore necessary to add indirect taxes to GDP at factor cost, since the market price exceeds
GDP at factor cost by this amount. Similarly, subsidies are paid to the producer and therefore
form part of factor income but not of the market price; for this reason it is subtracted from GDP
at factor cost to reach at GDP at market price. We therefore have to add indirect taxes from the
GDP at factor costs and deduct subsidies.
b. Depreciation (or capital consumption allowance) is added to get from net domestic product to
gross domestic product. Like the indirect taxes, the payment on account of depreciation does not
become available to the households (factors) in the form of income. In other words depreciation
is no part of the factor incomes. Therefore, while estimating the GNP by the Income Method, we
have to add depreciation charges to the factor incomes.

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

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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 at factor cost?
b. What is the value of GDP at market price?
Solution:
a. Net domestic product = 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

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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 available for estimating the total output of the economy and it 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. This approach measures GDP in terms of values added by each
sector of 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. In this approach GNP can be
calculated by adding up all value added at each sector of the economy.
Table1: A hypothetical data to show how to calculate value added in a five 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
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 Firm E: Bread Retail Seller 550 80
Total value added (Total 550
income)

The above table (Tab.1) depicts that firm A; wheat producer provides 350-dollar worth of flour
to firm B, a flour producer. Firm A pays out the 350 dollars it receives in wages, and salaries,
rents, interests and profits. Firm B process flour (grind wheat) and sells to Firm C, a bread baker
for 380. As noted above, 380 dollar goes to firm A, and the remaining 30-dollar is used by firm
B, to pay wages, salaries and rents, profits and interests for the resources needed in process of
flour production. Firm C, sells bread to firm D, a bread whole seller which in turn sells to firm E,
a retailer of bread, and the at last it bought for 550 dollar by a consumer, the final user of the
product.
At each stage, the difference between what a firm pays for the product and what it receives for its
sale is paid out as wages, rent, interest and profits for the resources used by the firm in helping to
produce and distribute the bread. In our example the total value added is 550 dollar.

2.3.Other Social Accounts

The national income accounts include other measures of income that differs slightly in definition
from GDP. It is important to be aware of the various measures, because economists and the press
often refer to them. To see how the alternative measures of income relate to one another, we start
with GDP and add or subtract various quantities.

i. 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

Whereas GDP measures the total income produced domestically, GNP measures the total income
earned by all resources of a nation. For instance, if a Japanese resident owns an apartment
building in Addis, the rental income he earns is part of Ethiopian GDP because it is earned in

15
Ethiopia. But because this rental income is a factor payment to abroad, it is not part of Ethiopian
GNP.

ii. To obtain 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.

iii. The next adjustment in the national income accounts is for indirect business taxes, such as
sales, excise and property 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 (Ethiopian-owned resources) in the economy has
earned(got money by working).The national income accounts divide national income into five
components, depending on the way the income is earned.

iv. A series of adjustments takes us from national income to personal income, the amount of
income that households and non-corporate businesses receive.

a. First, we reduce national income by the amount that corporations earn but do not pay out to the
stakeholders, either because the corporation have retained earnings(undistributed corporate
profit) or because they are paying taxes to the government. This adjustment is made by
subtracting corporate profits (which equals the sum of corporate taxes, dividends, and retained
earnings) and adding back dividends.

b. Second, we increase national income by the net amount the government pays out in transfer
payments. This adjustment equals government transfers to individuals minus social insurance
contributions paid to the government.

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c. Third, we adjust national income to include the interest that households earn rather than the
interest that business firms pay. This adjustment is made by adding personal interest income and
subtracting net interest. (The difference between personal interest and net interest arises in part
from the interest on the government debt.) Thus,

Personal Income =National Income−Corporate Profits−Social Insurance Contributions−Net

Interest + Dividends+ Government Transfers to Individuals+ Personal Interest Income.

Personal Income = National Income

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

v. 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.

Table 5: From GNP to Disposal personal income

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 (+) interest on the government debt.) Thus, +203

Gov. interest to persons(Personal interest

income - net interest)
9 Personal income = 6076
10 personal taxes -1206
11 = Disposal Personal Income (DPI) = 5956

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2.4.Nominal versus Real GDP

2.4.1.Definition

Nominal GDP represents the market value of all final goods and services measured in the price
of that period (current prices). But the value of different years’ GDPs can be usefully compared
only if the value of money (price) itself doesn’t change. Inflation (or deflation) complicates GDP
because GDP is price times quantity figure. The change in either the quantity of output or the
level of prices will affect the size of GDP since GDP equals the sum of P i Qi. But 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. Yet it 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. Thus, to
compare GDPs of different periods (or to see differences in production activities or economic
performance of a nation) nominal GDP must be adjusted for price level changes. In other words,
real GDP should be used. 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.

A better measure of economic well-being would count the economy’s output of goods and
services and would not be influenced by changes in prices. Real GDP is a measure value of
output that has been adjusted for price level changes. Simply Real GDP is the value of final
output produced in a given period, measured in the using prices of a base year (constant prices).
To distinguish increases in the quantity of goods and services from increase in their prices, we
must construct a measure of GDP at that time taking into account price level changes.

Real GDP may be calculated using:

a. Base year fixed prices: real GDP 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.

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b. Chain-weighted measures of GDP: over time the prices would become more and more
dated. For instance, the price of computers has fallen substantially in recent years, while the price
of a year at college has risen. When valuing the production of computers and education, it would
be misleading to use the prices that prevailed ten or twenty years ago. To solve this problem, the
base year changes continuously over time. This new chain-weighted measure of real GDP is
better than the more traditional measure because it ensures that the prices used to compute real
GDP are never far out of date.

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

The nominal GDP of each year can be computed as by multiplying the amount produced with the
price of commodity.

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(in 2011/12)) + (price of
machinery(2011/12) * quantity of machinery(in 2011/12))

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  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
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

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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
Nominal GDP
real GDP:GDP Deflator=
Real GDP

GDP Deflator: measures the current price of output relative to its price in the base year. It
reflects what’s happening to the overall level of prices in the economy.

The definition of 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

In this form, you can see how the deflator earns its name: it is used to deflate (that is, take
inflation out of) nominal GDP to yield real GDP.

To better understand this, consider an economy with only one good, bread. Let P is the price of
bread Q is the quantity sold, and then
 Nominal GDP is the total number of dollars spent on bread in that year, P × Q.
 Real GDP is the number of loaves of bread produced in that year(quantity of bread) times
the price of bread in some base year, P base × Q.
The GDP deflator is the price of bread in that year relative to the price of bread in the base year,
P/P base. Thus, GDP Deflator measures price of a current year relative to price of a 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

Using these computed values of nominal GDP and real GDP we can compute the GDP Deflator
for each year.
Nominal GDP(2010/11)
GDP Deflator(2010/11)=
Real GDP(2010/11)

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

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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 ((1.2164-1)*100) 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

Price Index: Measures the combined price of a particular collection of goods and services in a
specific period relative to the combined price of an identical group of goods and services in a
given reference period.
A dollar today doesn’t buy as much as it did 20 years ago. The cost of almost everything has
gone up. This increase in the overall level of prices is called inflation, and it is one of the primary
concerns of economists and policymakers. The most commonly used measure of the level of
prices (or of the cost of living) is the consumer price index (CPI).

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Central statics Authority (CSA) has the job of computing the CPI. 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.

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.

The index tells us how much it costs now to buy a market basket of products relative to how
much it cost to buy the same basket of goods in the base year.

How should economists aggregate the many prices in the economy into a

single index that reliably measures the price level?

They could simply compute an average of all prices. Yet this approach would treat all goods and
services equally. Because people buy teff than salt, the price of teff should have a greater weight

in the CPI than the price of salt. The composition of the CPI-basket is determined by the larger

the weight in the basket.

The CSA weights different items by computing the price of a basket of goods and services
purchased by a typical consumer .The CPI is the price of this basket of goods and services
relative to the price of the same basket in some 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,

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  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 market

Item Quantity Base-year price 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

CPI market basket Cost of CPI market

Item Quantity current price basket
(2011/12)

Teff 100 1200 120,000

Soft drink 75 8 600
Machiney 25 2500 62,500
Cost of CPI-basket at current period prices (in 2011/12) 183,100

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(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%) = 1

For 2011/12, the CPI is: (183,100/150,525) (100%) = 1.2164

Inflation rate over a period of time can be computed using the CPI as follows.
CPI t  CPI t 1
Infilationrate( )  *100%
CPI t 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. Thus, an increase in the price of goods bought by firms or the government will show
up in the GDP deflator but not in the CPI.

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.

Economists call a price index with a fixed basket of goods a Laspeyres index and a price index
with a changing basket a Pasche index. Neither of these two price indices is clearly superior to
the other in measuring the cost of living. Moreover, the difference between them is usually not
large in practice. Thus, the CPI is also used to deflate nominal GDP so as to arrive at the real
GDP.

2.6.GDP and Welfare

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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.

1. 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 because they represent transfer of existing
assets but the brokers’ services.
2. Household services (house cleaning, childcare, meal preparation, home repair
maintenance) are excluded.
3. Illegal and underground economic activities are not included in GDP, because these
activities are not reported.
4. Leisure time is not included in GDP.
5. Volunteer work.
6. The quality, composition and distribution of output
7. Cost of environmental damage: The costs of environmental damage are not subtracted
from the market value of final products when GDP is calculated. It over estimates the
value of output.
8. GDP accounting ignores the depletion of natural resources.

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