MACROECONOMICS I

CHAPTER 2 – NATIONAL INCOME ACCOUNTING

2.1. Introduction

Scientists, economists, and detectives have much in common: they all want to figure out what‟s going
on

in the world around them. To do this, they rely on theory and observation. They build theories in an

attempt to make sense of what they see happening. They then turn to more systematic observation to

evaluate the theories‟ validity. Only when theory and evidence come into line do they feel they

understand the situation. This chapter discusses the types of observation that economists use to
develop

and test their theories.

Casual observation is one source of information about what‟s happening in the economy. When you go

shopping, you see how fast prices are rising. When you look for a job, you learn whether firms are hiring.

Because we are all participants in the economy, we get some sense of economic conditions as we go

about our lives. However, the most important source of information for economic analysis is economic

data or statistic.

Today, economic data offer a systematic and objective source of information, and almost every day the

newspaper has a story about some newly released statistic. Most of these statistics are produced by the

government. Various government agencies survey households and firms to learn about their economic

activity—how much they are earning, what they are buying, what prices they are charging, whether they

have a job or are looking for work, and so on. From these surveys, various statistics are computed that

summarize the state of the economy. Economists use these statistics to study the economy; policy
makers

use them to monitor developments and formulate policies.

National income accounting is accounting system that is used to measure aggregate economic activities.

It is an official measurement of the flow of income and product in a given economy. Economic activity

gives rise to both output and income earned by the persons and machines involved in the productive
activity. The overall level of economic activity can be measured by adding up either the value of

output produced or the levels of income earned. This chapter focuses on the methods and statistics that

economists and policymakers use most often to measure the volume of economic activities. The most

frequently used statistics is the Gross domestic product, or GDP, and it tells us the nation‟s total income

and the total expenditure on its output of goods and services. The consumer price index, or CPI,
measures

the level of prices. The unemployment rate tells us the fraction of workers who are unemployed. In this

chapter, we will see how these statistics are computed and what they tell us about the economy.

2.2. Measuring the Value of Economic Activity: Gross Domestic Product

Gross domestic product, or GDP, is often considered the best measure of how well the economy is

performing. In Ethiopia this statistic is computed every year by the Central Statistics Agency, from a large

number of primary data source. The primary sources include both administrative data, which are

byproducts of government functions such as tax collection, education programs, defense, and
regulation,

and statistical data, which come from government surveys of, for example, retail establishments,

manufacturing firms, and farm activity. The purpose of GDP is to summarize all these data with a single

number representing the dollar value of economic activity in a given period of time.

There are two ways to view this statistic. One way to view GDP is as the total income of everyone in the

economy. Another way to view GDP is as the total expenditure on the economy‟s output of goods and

services. From either viewpoint, it is clear why GDP is a gauge (measure) of economic performance.

GDP measures something people care about—their incomes. Similarly, an economy with a large output
of

goods and services can better satisfy the demands of households, firms, and the government.

How can GDP measure both the economy‟s income and its expenditure on output? The reason is that

these two quantities are really the same: for the economy as a whole, income must equal expenditure.

That fact, in turn, follows from an even more fundamental one: because every transaction has a buyer
and
a seller, every dollar of expenditure by a buyer must become a dollar of income to a seller. When Joe

paints Jane‟s house for $1,000, that $1,000 is income to Joe and expenditure by Jane. The transaction

contributes $1,000 to GDP, regardless of whether we are adding up all income or all expenditure. To

understand the meaning of GDP more fully, we turn to national income accounting, the accounting

system used to measure GDP and many related statistics.

2.2.1 Income, Expenditure, and the Circular Flow

Imagine an economy that produces a single good, bread, from a single input, labor. Figure 2-1 illustrates

all the economic transactions that occur between households and firms in this economy.

 The inner loop in Figure 2-1 represents the flows of bread and labor. The households sell their

labor to the firms. The firms use the labor of their workers to produce bread, which the firms in

turn sell to the households. Hence, labor flows from households to firms, and bread flows from

firms to households.

 The outer loop in Figure 2-1 represents the corresponding flow of dollars. The households buy

bread from the firms. The firms use some of the revenue from these sales to pay the wages of

their workers, and the remainder is the profit belonging to the owners of the firms (who

themselves are part of the household sector). Hence, expenditure on bread flows from households

to firms, and income in the form of wages and profit flows from firms to households.

Revenue of firms Consumption expenditure

Expenditure of firms

Figure 2.1: The Circular flow in a closed two-sector economy

Revenue of firms

Legend: Flow of goods and services

Flow of money payment or receipt

GDP measures the flow of dollars in this economy. We can compute it in two ways. GDP is the total

income from the production of bread, which equals the sum of wages and profit—the top half of the
circular flow of dollars. GDP is also the total expenditure on purchases of bread—the bottom half of the

circular flow of dollars. To compute GDP, we can look at either the flow of dollars from firms to

households or the flow of dollars from households to firms.

These two ways of computing GDP must be equal because, by the rules of accounting, the expenditure
of

buyers on products is income to the sellers of those products. Every transaction that affects expenditure

must affect income, and every transaction that affects income must affect expenditure. For example,

suppose that a firm produces and sells one more loaf of bread to a household. Clearly this transaction

raises total expenditure on bread, but it also has an equal effect on total income. If the firm produces
the

extra loaf without hiring any more labor (such as by making the production process more efficient), then

profit increases. If the firm produces the extra loaf by hiring more labor, then wages increase. In both

cases, expenditure and income increase equally.

In an economy that produces only bread, we can compute GDP by adding up the total expenditure on

bread. Real economies, however, include the production and sale of a vast number of goods and
services.

To compute GDP for such a complex economy, it will be helpful to have a more precise definition.

 Gross Domestic Product (GDP) is the market value of all final goods and services produced in a

country in a given year. Let us look at this definition in more detail.