Macroeconomics

CHAPTER TWO: NATIONAL INCOME ACCOUNTING

2.1. The Concept of National Income Accounting
National income is the aggregate factor income (i.e., earnings of labour, capital, etc.), which arises from the
current production of goods and services by the nation's economy. The nation's economy refers to the
factors of production (labour, capital, etc.) supplied by the normal residents of the national territory.
National Income Accounting (NIA) is an accounting record of the level of economic activities of an
economy. It is the aggregate monetary value of all final goods and services produced in a country
during a year. It is a measure of an aggregate output, income and expenditure in an economy.
Why do we need to study NIA?
 It enables us to measure the level of total output and growth in a given period of time, and to explain
the causes for such level of economic performances.
 It enables us to observe the long-run trend of the economy. For example, investment, consumption,
employment, etc.
 It provides information to formulate policies and design plans.
 Knowledge of Structural Changes: National income accounts reveal the structural changes taking
place in an economy.
 Significance for Economic Analysis: National income is an important concept of economic theory.
The study of national income accounts is essential to identifying interrelationships between different
sectors of an economy.

Features of National Income Account

A description of the above definition brings the following features of national income
 National income is the income of a country,
 It is counted for a period of one accounting year,
 National income includes all final types of goods and services in calculation,
 It measures the flow of goods and services only i.e. national income is a flow concept, and
 It can be expressed in terms of monetary value of goods and services.
Determinants of National Income (Factors Determining National Income)
1.Quantity and quality of factors of production: Factors of production include: labour, land capital,
entrepreneurship and information technology.
 Land: quantity and quality of land, natural resources on earth determine the quantity and
quality of national income.
 Labour: has doubled influences since labour is at the same time both a factor of production as
well as the consumer of what is produced. Quality of labour depending on intelligence,
education and training influences the volume of industrial production.
 Capital: from simple, primitive tools to the most modern type of industrial equipment.
 Entrepreneurial ability: is also an important element to consider with in the determination of
the size of national income of a country.
 Information technology: how does it affect national income?
2. The state of technical know-how: A country with a poor technical knowledge cannot have a large-
sized national income, because it will not be in a position to make the best possible use of its
resources.
3. Political stability: political stability is an essential prerequisite for maintaining production at the
highest level.
4. Means of transportation and communication: a well-developed means of transportation and
communication facilitate the exchange of goods and services, and so increase the mobility of factors

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of production. It also strengths the trade activity in the economy in the country while rising national
income.
5. Availability of natural resources: availability of natural resources and its maximum exploitation
increases the size of national income.

2.2. The Concepts of GDP and GNP

Gross Domestic Product (GDP): It is the market value of all the final goods and services produced within
the domestic territory of a country during a given fiscal year. This means:
GDP:-
 measures the current production only (sales of used goods is not included as part of GDP).
 is an aggregate measure of value (monetary not quantity).
 measures gross value of the products.
 can be calculated in a given time period (note that GDP is a flow not a stock concept).
It is worthwhile, however, to recognize important limitations of the GDP concept.
- Non-market productive activities are left out: Because, goods and services are evaluated at market
prices in GDP, so that non-market production is left out. E.g. Homemaker service.
- The underground economy is left out: GDP also excludes illegal forms of economic activity and legal
activities that are not reported to avoid paying taxes: the underground economy.
- GDP is not a welfare measure: GDP measures production of goods and services; it is not a measure of
welfare or even of material well-being.
- Transfer payments: e.g. the state pension paid to retired people; income support paid to families on low
incomes; the jobseekers' allowance given to the unemployed and others are not included in GDP.
Gross National Product (GNP):- is the total value of al final goods and services currently produced by
domestically owned factors of production in a given period of time (usually one fiscal year),
irrespective of their geographical locations.
 The gross national product is the basic social accounting measure. It is the most frequently used
national aggregate income in economic discussions.
 Strictly speaking, then GNP is the money value of the total national production for any given period.
GNP = GDP + NFI
Where NFI is Net Factor Income received from abroad
NFI = (factor income received from abroad by a country's citizens) – (factor income paid for
foreigners to abroad).
When NFI > 0, then GNP > GDP
NFI < 0, then GNP < GDP
NFI = 0, then GNP = GDP

The distinction between GDP and GNP

 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 with in the country's territory with in a
given period, the factors of production used might not be domestically owned.
 When GDP exceeds than GNP, residents of a given country are earning less abroad than foreigners
are earning in that country.

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2.3. Approaches of Measuring National Income (GDP/GNP)

There are three methods of estimating the GNP of a country. These are: expenditure approach,
income approach and value added approach. All the three methods lead to the same result.

2.3.1. Expenditure approach

Each unit of goods and services produced is matched by an expenditure on that unit. Consumers buy most
goods and services produced in the country. But, there are some goods and services, which remain unsold. If
the unsold goods and services were regarded as having been bought by producers who hold them as stocks or
inventories, then the monetary value of the total national production would be equal to the total national
expenditure.

Under the expenditure approach to GDP, 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, motorcars, 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 expenditures on the
purchase of a house which 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, houses, 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. Three points should be carefully noted here.
Firstly, this sub-head includes capital or investment goods needed not only to replace the existing
depreciated capital goods, but also the capital goods require increasing the society's production
of goods and services.
Secondly, the term ‘investment’ here means real investment in the Keynesian sense rather than
financial investment. It means the purchase of real investment goods, such as, buildings,
machinery, plant, etc. produced during the year. If a person buys 5-year old machinery, it is not
real investment, though it may be called financial investment, because that machinery was
included in the GNP five years ago when it was manufactured and sold first.
Thirdly, ‘investment’ here does not include mere financial transfer, such as, the purchase of existing
stocks and shares on the stock exchange. The purchase of existing stocks and shares does not
represent new investment for the purposes of the national income accounts, since it does not
involve any production.
C. Governments' Purchases of Goods and Services (G): The government's 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, 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), but are not part of GDP.

D. Net Export (NX): A part of output of a country is sold out 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. Net export
equals Export (X) minus import (M): NX = X - M

Therefore:
GDP = C+I + G + NX

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Example1. Compute GNP and/or GDP using the following hypothetical data of a certain country.
Value in billion birr
1. Personal consumption expenditure 6320
2. Government spending on goods and services 5000
3. Transfer payment 650
4. Income earned by foreigners in the country 500
5. Private investment 5780
6. Income earned by citizens abroad 800
7. Export 500
8. Import 750
Using the appropriate method, calculate GDP and GNP
Solution
GDP = C + I + G + NE
= 6320 + 5780 + 5000 + 500 - 750
= 16850 billion birr
GNP = GDP + NFI
= 16850 + (800 –500)
= 17150 billion birr
 Precautions of the Expenditure Approach
 To avoid double counting, expenditure on all intermediate goods and services is excluded.
 Government expenditure on all transfer payments, such as scholarships, unemployment allowances,
old age pensions, etc., is excluded because non-productive services are rendered by the recipients in
exchange.
 Expenditure on purchase of second-hand goods is excluded from national income because this type
of expenditure is not on currently produced goods.
 Expenditure on purchase of old shares/bonds or new shares/bonds etc. is excluded because it is not
payment for currently produced goods and services. It shows mere transfer of property from one
person to another.
 Intermediate goods and value added: GDP includes only final goods not intermediate goods. Adding
intermediate goods is a double counting. Or the other way is to compute the value of all final goods
and services being the sum of the value added at each stage of production.

2.3.2. Income approach

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:

A. Wages and salaries of the employees (or compensation to employees) (W/S),

- It 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.
B. Proprietors income (I)
- It includes the incomes earned by individual proprietors, parents and self-employed persons.
C. Rental incomes of persons (R)
- It comprises rental incomes earned by individuals on agricultural and non-agricultural property.
D. Corporate profits (𝛑)
- It includes corporate profits earned by business corporations before the payment of corporate
profit taxes or the payment of dividends to the shareholders. Thus, corporate profits, used in

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calculating the GDP, are equal to the sum of corporate profit taxes plus dividends paid to the
shareholders plus undistributed corporate profits.
E.Net interest income (i)
- It contains net interest earned by individuals from sources other than the organs of the
government.
F. Indirect business taxes (IBT)
- Taxes levied by the government on production and sale of commodities are called indirect taxes-
for example, excise duty, sales tax, custom duty, etc.
G. Depreciation (D)
- It is the value of the existing capital stock that has been consumed (used up) in the process of
producing output.
H. Subsidy (S)

Therefore, GDP = W/S + i + R + I + 𝛑 + IBT + D – S – TR

I. Transfer payments (TR)

⇒ GNP = W/S + i + R + I + 𝛑 + IBT + D – S – TR + NFI

Example: Given the following data on different incomes earned.

Types of income Amount (in billion birr)

Compensation of employees 10,800
Proprietor’s income 400
Rental income 600
Corporate profit 4000
interest income 170
Deprecation 1600
Indirect business taxes 200
Income earned by foreigners in the country 500
Income earned by citizens abroad 800
1. Compute GDP using income approach.
2. Compute GNP using income approach.

Solution
1. GDP using income approach is determined as follows:
GDP = W/S + i + R + I + Π +IBT+ D – TR – S
= 10800 + 170 + 600+ 400 + 4000 + 1600 + 200 – 0 – 0 = 17770 billion birr
2. GNP = GDP + NFI
= 17770 + 800 – 500 = 18070 billion birr

2.3.3. Product or value added approach

Value added is defined as the difference between total value of the output of a firm and the value of inputs
bought from other firms. The value added approach is better than the final product approach since it
measures the contribution of each producing unit in the domestic economy without any possibility of double
counting.

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Example: Consider a hypothetical data below:

Stages of Production Sales Value of the Product Value Added
Firm A, sheep ranch $ 60 $ 60
Firm B, Wool processor $ 100 $ 40
Firm C, suit manufacturer $ 125 $ 25
Firm D, clothing wholesaler $ 175 $ 50
Firm E, clothing retailer 250 $ 75
Total sales value $ 710
Value added (total income) $250

Thus, by calculating and summing the values added by all firms (sectors) in the economy, we can determine
the GDP, that is, market value of total output. GDP can also be determined either by adding up all that is
spent on this year's total output or by summing up all the incomes derived from the production of this year's
output. That is,
The amount spent on this The money income derived from the
=
year’s total output. production of this year’s output.
(Expenditure-side) (Income-side)

NB: In principle, all methods should arrive at the same result.

2.4.Other Social Accounts (NNP, NDP, NI, PI and PDI)

There are also other social accounts, which can be derived from GDP and GNP and have equal importance.
Hence, in this section we will see additional social accounts.
These are:
 Net National Product (NNP)
 Net Domestic Product (NDP)
 National Income (NI)
 Personal Income (PI)
 Personal Disposable Income (PDI)
Net National Product (NNP) and Net Domestic Product (NDP)
GNP and GDP as measures of the economy's annual output may have defects because they fail to take into
account capital consumption allowance (depreciation), which is necessary to replace the capital goods used
up in that year's production. Let us see this using example. Suppose that in 1990, the economy had 10 billion
birr worth of capital goods. Assume during the same year 4 billion birr worth of equipment and machinery
was used up in producing a GNP of 60 billion birr. Can we say the GNP value 60 billion birr accurately
measures 1990's output?
Hence, net national product is a more accurate measure of the economy's annual output than gross national
product and it is given as:
Net National Product (NNP) = GNP – Capital consumption allowance

Net Domestic Product (NDP) = GDP – Capital consumption allowance

National Income (NI)

National income is the income earned by economic resource (input) suppliers for their contributions of land,
labor, capital and entrepreneurial ability, which involved in the given year's production activity. It measures
the income received by resource supplier for their contributions to current production. However,
from the components of NNP, indirect business tax, which is collected by the government, does not

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reflect the productive contributions of economic resources because government contributes nothing
directly to the production in return to the indirect business tax. Hence, to get the national income,
we must subtract indirect business tax from net national product.
National Income (NI) = NNP – indirect business tax
= NDP – indirect business tax + NFI

Personal Income (PI)

Part of national income like social security contribution (payroll taxes), and corporate income taxes are not
actually received by individuals. Therefore, they should be subtracted from the national income. On the other
hand, transfer payments, which include welfare payments, veterans' payments and unemployment
compensations are not currently earned. Therefore, in order to get personal income (PI) which is a measure
of income received by individuals, we must subtract from national income those types of income which are
earned but not received and add those types of income which are received but not currently earned.
Personal Income (PI) = National income (NI) – (social security contribution: SSC + corporate profits +
Net Interest) + (Dividend + Gov't transfer payment + personal interest income)
Personal Disposable Income (PDI)
Personal disposal income is the difference between personal income and personal tax and non-tax payments .
It is the amount of income which households divided it as saving and consumption. Personal taxes
include personal income taxes, personal property taxes and inheritance taxes.
Personal Disposable Income (PDI) = Personal Income – personal income taxes
= C+S

Per Capita Income (PCI)

PCI = GNP
Population
Exercise: If the Ethiopian GDP is 2.2 trillion Birr and its population is 107 Million, compute PCI?

2.5. Nominal GDP and Real GDP

GDP measurement may take the form of nominal or real GDP.
Nominal GDP:- it is the monetary value of currently produced goods and services measured at current
prices. It changes over time if there is a change in physical output or a change in prices or both.
Real GDP:- It is a measure of real production measured by removing the effect of price change on the GDP
measurement. It is the value of currently produced goods and services measured at constant price. It truly
reflects the performance and level of economic growth in an economy. It is a better tool for making a year-
to-year comparison of changes in the physical output of goods and services than nominal GDP.

2.6. Measuring the Cost of Living

A. Consumer Price Index
Consumer Price Index (CPI):- is a measure of the overall cost of the goods and services bought by a
typical consumer. It puts the price of many goods and services into a single index measuring the overall level
of prices.

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CPI measures the retail prices of a fixed “market basket” of several thousand goods and services purchased
by households. It is an explicit price index in the sense that it directly measures movements in the weighted
average of the prices of goods and services in the market basket. Thus, CPI is the price of the “ market
basket” of goods and services to price of the same basket in some base year.
Five steps in calculating CPI:
1. Fix the Basket: The first step in computing the CPI is to determine which prices are most important to
the typical consumer. If the typical consumer buys more Injera than bread, then the price of Injera is
more important than the price of bread and, therefore, should be given greater weight in measuring the
cost of living.
2. Find the Prices: The second step in computing CPI is to find the prices of each of the goods and services
in the basket for each point in time.
3. Compute the Basket's Cost: The third step is to use the data on prices to calculate the cost of the basket
of goods and services at different times.
4. Choose a Base Year and Compute the Index: The fourth step is to designate one year as the base year,
which is the benchmark against which other years are compared. To calculate the index, the price of the
basket of goods and services in each year is divided by the price of the basket in the base year, and this
ratio is then multiplied by 100. The resulting number is the consumer price index; which is calculated as:

Where:

5. Compute the Inflation Rate: The fifth and final step is to use the CPI to calculate the inflation rate,
which is the percentage change in the price index from the preceding period. That is, the inflation rate
between two consecutive years is computed as follows:

For example, suppose that a typical consumer buys 5 apples and 2 oranges every month. Then the basket of
goods consists of 5 apples and 2 oranges, and the CPI in 2002 is:

In this CPI calculation, 2001 is the base year. The index tells how much it costs to buy 5 apples and 2
oranges in the current year relative to how much it cost to buy the same basket of fruit in 2002.

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Weaknesses of the CPI as a Measure of the Average Level of Prices

 Substitution bias
o When the price of one good changes, consumers often respond by substituting another good in
its place.
o The CPI does not allow for this substitution; it is calculated using a fixed basket of goods and
services.
o This implies that the CPI overstates the increase in the cost of living over time.
 Introduction of new goods
o When a new good is introduced, consumers have a wider variety of goods and services to choose
from.
o This makes every dollar more valuable, which means that there is an increase in the purchasing
power of dollar.
o Because, the market basket is not revised often enough, these new goods are left out of the
bundle of goods and services included in the basket.
 Unmeasured quality change:
o If the quality of a good falls from one year to the next, the value of a dollar falls; if quality rises,
the value of the dollar rises.
o Attempts are made to correct prices for changes in quality, but it is often difficult to do so
because quality is hard to measure.
B. GDP Deflator:- Another measure of the average price level is the GDP deflator. This index
measures the average level of prices of all goods and services that make up GDP (including
investment and consumption goods not in the CPI). The GDP deflator is the ratio of nominal GDP to
real GDP. Because, nominal GDP is current output valued at current prices and real GDP is current
output valued at base-year prices, the GDP deflator reflects the current level of prices relative to the
level of prices in the base year.

There are three key differences between CPI and GDP deflator:
a. GDP deflator measures the price of all goods and services produced, whereas the CPI measures the
prices of only goods and services bought by consumers. Thus an increase in the price of goods and
services bought by firms and/or government will be shown up in the GDP deflator but not in the CPI.
b. GDP deflator includes only those goods produced domestically.
c. CPI assigns fixed weights to the price of different goods and services whereas GDP deflator assigns
changing weights. In other words, the CPI is computed using a fixed basket of goods while the GDP
deflator allows the basket of goods to change overtime as the composition of GDP changes.
It is difficult to take GDP deflator or CPI as a superior measure of cost of living. Both have their own
advantages and disadvantages. For instance, assume the prices of different products are changing by different
amount. The fixed basket index – CPI – tends to overstate the cost of living because it does not account that
consumers have the opportunity to substitute less expensive goods for more expensive ones. The changing
basket index – GDP deflator – understates the increase in cost of living. While it accounts for substitution of

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alternative goods, it does not reflect the reduction in consumer's welfare that may result from such
substitutions.

2.7. GDP and Welfare

Does GDP or GNP indicate how income is distributed among people in a country? It is debatable since GDP
cannot indicate how the currently produced outputs are distributed among the population. GDP is a measure
of the economic prosperity of a country compiled as output or income. There is a strong correlation between
the development in GDP and changes in several important social factors, including tax payments and
unemployment, and to a lesser extent, health and education.
However, GDP is regularly criticized for not presenting a fair view of welfare. If GDP is a poor measure of
welfare, focusing one-sidedly on increasing GDP may lead to misguided political decisions. For example,
Nobel laureate Joseph Stieglitz has argued that the objective of the highest possible GDP growth will result
in reduced welfare. The criticism of GDP as a measure of welfare is two-fold.
 Firstly, there are a number of compilation problems, including the breakdown by price and quantity
changes and the calculation of public output. These problems can cause both the level of GDP and
GDP growth to deviate from actual output. Furthermore, changes in the terms of trade may cause
income to develop differently from output. As a result, applying the level of GDP and GDP growth
as measures of economic prosperity is not fully possible.
 Secondly, a number of factors of major significance to welfare are not included in GDP. A number
of factors may affect welfare, e.g. leisure time, health condition and level of education. These
welfare indicators do not seem to provide a significantly better picture of welfare due to the strong
correlation between e.g. health and education, and GDP.
Instead, other welfare indicators attempt to measure welfare directly, including by means of questionnaires
on the subjective feeling of happiness. The patterns of these indicators are different from that of GDP.
There is a strong cross-country correlation between GDP and happiness, but measured over time, happiness
seems to be independent of the development in GDP. One explanation of this apparent paradox is that
happiness is related to the relative position in the income hierarchy rather than to the absolute level of
income. Consequently, the feeling of happiness is not increased by higher income if everyone else has also
become more affluent.
In addition to being a poor measure of welfare, GDP is also criticized of not including sustainability.
Sustainability can be viewed as ongoing maintenance of necessary resources, e.g. the capital stock, the
"natural capital" measured by the quantity of natural resources and environmental quality as well as the
amount of human capital. Indicators illustrating sustainability should be analyzed in parallel with welfare
indicators.

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Despite a number of reservations, GDP as an indicator of prosperity should play a key role in the welfare
debate. Increased prosperity can be used to improve areas that are deemed to be central to welfare.
Furthermore, GDP is strongly correlated with a number of factors of importance to welfare, including
unemployment, health and education. Aspects affecting welfare but not included in GDP should be part of
the political debate, but they should not necessarily be comprised by a single welfare indicator.

2.8. Common Macroeconomic Problems

2.8.1. The business cycle
Inflation, growth and unemployment are related through the business cycle. The business cycle is the more or
less regular pattern of expansion (recovery) and contraction (recession) in economic activity around the path
of trend growth. Inflation, growth and unemployment all have clear cyclical patterns.
- At a cyclical peak – economic activity is high relative to trend.
- At a cyclical trough – the low point in economic activity is reached.
Trend path of GDP is the path that GDP would take if factors of production were fully employed.

Peak
Recession
Recovery

Trough

Output is not always at its trend level, that is, the level corresponding to full employment of factors of
production. Rather output fluctuates around the trend level.
During an expansion (recovery) the employment of factors of production increases. Output rise above the
trend because people work overtime and machinery is used for several shifts. During a recession
unemployment increases and less output is produced than can in fact be produced with the existing resources
and technology. The wavy line shows these cyclical departures of output from trend. Deviations of output

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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.

The output gap allows us to measure the size of the cyclical deviations of output from its potential output
level or trend output. Positive gap, when potential output is greater than actual output, more resources
become unemployed and actual output falls below potential output, that is, the economy is in a recession.
Negative gap, when actual output is greater than potential output, resources are over employed, like workers
are working overtime and machineries are more utilized by shift, that is, the economy is expanding and
accessibility of job are widespread.
From the business cycle it is assumed that often a long expansion reduces unemployment too much, causes
inflationary pressure, and therefore triggers policies to fight inflation, and such policies usually create
recessions.

2.8.2. Unemployment and inflation

The Phillips curve describes an empirical relationship between inflation and unemployment; the higher the
rate of unemployment, the lower the rate of inflation.
When policymakers move the economy up along the short-run aggregate supply curve, they reduce the
unemployment rate and raise the inflation rate. Conversely, when they contract aggregate demand and move
the economy down the short-run aggregate supply curve, unemployment rises and inflation falls. This trade-
off between inflation and unemployment, is called the Phillips curve.
It was made in the 1950's in Great Britain and has since become a cornerstone of macroeconomics. It shows
that high rates of unemployment are accompanied by low rates of inflation and vice versa. The curve
suggests that less unemployment can always be attained by incurring more inflation and that the inflation rate
can always be reduced by incurring the costs of more unemployment. In other words, the curve suggests that
there is a trade-off between inflation and unemployment.
Economic events since 1970, particularly in 1974 and in 1981 were accompanied by both high
unemployment and high inflation, led to skeptical consideration of the Philips curve. The modern view on
the trade-off between inflation and unemployment, is, there is a relationship between inflation and
unemployment of the Phillips curve type in the short-run. But the short-run Phillips curve does not remain
stable; it shifts as expectations of inflation changes. In the long-run there is no trade-off worth speaking
between inflation and unemployment, i.e. the unemployment rate is basically independent of the long-run
Inflation rate
inflation rate.

The Philips curve

0 Unemployment rate
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2.8.3. Growth and unemployment: high GDP growth is accompanied by declining unemployment.
Economic expansion is associated with falling unemployment rate. Periods of recession are
associated with low growth and rising unemployment.
Okun's law: the relationship between real growth and changes in the unemployment rate is known as Okun's
law. Since employed workers contribute to the production of goods while unemployed workers do not,
increases in the unemployment rate should be associated with decreases in the growth rate of GDP.
Okun's law states that unemployment rate declines when growth is above the trend rate of 2.25 percent.
Specifically, for each percentage point of growth in real GDP above the trend rate that is sustained for a year,
the unemployment rate declines by half (0.5) percentage point.

Unemployment
The total population of a country can be categorized into two as the working age population and outside the
working age (which is country specific). Those in the working age could also be divided into two: currently
active and currently inactive. The people in the working age category who are either employed or actively
seeking a job constitute the labor force. A person is said to be unemployed if he/she is in the working age,
available for work, actively seeking work, but doesn’t have one during the census. The unemployment rate
measures the ratio of the number of unemployed to the total number of the labor force (x 100%).

UNEMPLOYMENT RATE = Number of Unemployed X 100%

Number of labor force
Types of Unemployment
1. Frictional Unemployment: is the usual amount of unemployment resulting from people who have
left jobs that didn’t work out and are searching for new employment, or people who are either
entering or re-entering the labor force to search for a job. This type of unemployment is very
common even if the economy is at full employment.
2. Structural Unemployment: this is because of the mismatch between the workers skills &
experience and the skills required by the employers who are hiring the workers. It also occurs
because of the mismatch between the location of job vacancies of the expanding industries and
location of job vacation of the unemployed workers. It is unemployment resulting from permanent
shifts in the pattern of demand for goods and services or from changes in technology such as
automation or computerization. To regain employment, workers in the pool of structurally
unemployed have to find jobs in other industries or locations, or learn new skills.

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3. Cyclical Unemployment: occurs when there are fewer vacancies than the unemployed. It is the
amount of unemployment resulting from declines in real GDP during periods of contraction
(recession), or in any period when the economy fails to operate at its potential.

The total amount of unemployment is the sum of frictional, structural and cyclical unemployment. Frictional
and structural unemployment result from natural and perhaps, unavoidable occurrences in a dynamic
economy. Cyclical unemployment, however, is the result of imbalances between aggregate purchases and the
aggregate production corresponding to full employment. Thus, cyclical unemployment receives the greatest
amount of attention since it is viewed as controllable/avoidable.

Full employment does not mean zero unemployment. It refers to the situation that occurs when the actual rate
of unemployment is no more than the natural rate of unemployment. The time, effort and transaction costs
required to find a new job guarantee that there will always be some unemployed workers looking for jobs.
The natural rate of unemployment is the percentage of the labor force that can normally be expected to be
unemployed for the reasons other than cyclical fluctuations in real GDP. In other words, the natural rate of
unemployment is the sum of the frictional and structural unemployment expected over the year.
An economy in which the actual unemployment rate is less than the natural rate of unemployment is termed
as an overheated economy. In such a case, the economy can produce more than the potential real GDP,
implying that the economy’s capacity output exceeds the potential real GDP. However, most economists
believe that this couldn’t happen for long periods without consequences that impair its future performance
and ultimately cause actual real GDP to decline to its potential level.
Cyclical Unemployment tends to increase during contractions (recessions). This negative relationship
between changes in real GDP and changes in the unemployment rate is known as Okun’s law.
The problem of (cyclical) unemployment is of great concern to economists because it has costs. The main
costs of cyclical unemployment are:
1. Output is lost (GDP falls) because the economy is not at full employment.
2. Distortional impact – unemployment usually hits poorer people harder than the rich and this
increases the concern about the problem.
3. The unemployed may have more leisure when not working. But, this benefit is more than offset by
the costs to the society since:
i. The value placed on that leisure is small as much of it is unwanted leisure ,and
ii. The government loses income tax revenue and thus, job lose hurts the society than the
individual.

Inflation
Inflation is the rate of increase in the general price level for an aggregate goods and services produced in a
nation. When inflation exists the purchasing power of a nation‘s currency declines over time. Deflation is the
opposite of inflation. Annual rates of inflation are measured by the percentage change in a price index from
one year to the other. The percentage change in the CPI is the most commonly used measure of inflation,
followed by the percentage change in the GDP deflator.

Rate of inflation = (CPIt – CPIt-1) x100%

CPIt-1
If the rate of inflation is positive, that will be inflation and if it is negative, it will be deflation. Measured in
this way, inflation is an average of the increases in the prices of all goods and services in the CPI market

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basket. The greater the weight attached to an item in the CPI, the greater the impact of a change in its price
on the CPI.

Here, we can identify three concepts:

Pure Inflation: refers to a condition that occurs when the prices of all goods rise by the same percentage
over the year. If an economy experienced pure inflation, there would be no changes in the relative prices of
goods. Thus, pure inflation does not provide consumers with any incentive to substitute one goods with the
other in their budget, nor does it change the profitability for sellers of one good rather than another.

Hyperinflation: inflation at very high rates prevailing for at least one year.

Disinflation: a sharp reduction in the annual rate of inflation. When disinflation occurs, the price level
continues to rise, but its rate of increase is sharply reduced.

Effects of Inflation
1. Inflation can result in a redistribution of income and wealth from creditors to debtors. As a result,
inflation can pay back loans in currency units that have less purchasing power than what they
borrowed. It can also harm savers, who, in effect are creditors because the purchasing power of
currency units in savings decreases as a result of inflation.
2. Hyperinflation seriously impairs the functioning of the economy by causing credit markets to
collapse and by wiping out the purchasing power of accumulated savings.
3. Actions taken in anticipation of inflation can adversely affect the performance of the economy.
When buyers and sellers try to anticipate, they base their economic decisions, in part, on the gains
and loses they expect to incur. This can affect the supply of and demand for particular goods and
services thereby distorting market prices.
4. Anticipated inflation can distort consumer choices by causing buyers to purchase goods now that
they might otherwise prefer to purchase in the future.

Causes of inflation
Inflation could be demand-pull inflation (where high aggregate demand is responsible for it) or cost-push
inflation (where adverse supply shocks are typically events that push up the costs of production).
Expansionary aggregate demand policies tend to produce inflation, unless they occur when the economy is at
high levels of unemployment.
There are two causes of rising and falling inflation:
 Demand–pull inflation: we know that the relationship between inflation and unemployment is
negative. Low unemployment pulls inflation rate up. Inflation caused because of high aggregate
demand is responsible for such type of inflation. For example, an increase in demand for the
products makes supplier to raise the price of the product in order to control the supply limitation,
which will come later.
 Cost-push inflation: Inflation also rises and falls because of supply shocks. An adverse supply
shock, such as the rise in world oil prices in the 1970s, implies a rise in inflation. The supply shocks
are typically events that push up the sots of production.
Costs of inflation
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 One cost is the distortion of the inflation tax on the amount of money people hold. A higher inflation
rate leads to a higher nominal interest rate, which in turn leads to lower real money balances.
 A second cost of inflation arises because high inflation induces firms to change their posted prices
more often. Changing prices is sometimes costly: for example, it may require printing and
distributing a new catalog. These costs are called menu costs, because the higher the rate of inflation,
the more often restaurants have to print new menus.
 A third cost of inflation arises because firms facing menu costs change prices infrequently; therefore,
the higher the rate of inflation, the greater the variability in relative prices. For example, suppose a
firm issues a new catalog every January. If there is no inflation, then the firm's prices relative to the
overall price level are constant over the year. Yet inflation is 1 percent per month, then from the
beginning to the end of the year the firm's relative price fall by 12 percent. Sales from this catalog
will tend to be low early in the year (when its prices are relatively high) and high later in the year
(when its prices are relatively low).
 A fourth cost of inflation results from the tax laws. Many provisions to the tax code do not take in to
account the effect of inflation. Inflation can alter individual tax liability, often in ways that
lawmakers did not intend.
 A fifth cost of inflation is the inconvenience of living in a world with a changing price level. Money
is the yardstick with which we measure economic transactions. When there is inflation, that yardstick
is changing in length.

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