CHAPTER TWO

2. NATIONAL INCOME ACCOUNTING

• National Income Accounting is an accounting record of the level of

economic performance of an economy.
• It is a measure of aggregate output, income and expenditure in an
economy
• National income refers to the market valueof all final goods and
services resulting from the productive activities by the residents of the
nation during the accounting year.

2.1 The concepts of GDP and GNP

 Gross Domestic Product (GDP)
• GDP is the total market value of a country's output.
• It is the market value of all final goods and services produced within a
given period of time by factors of production located within a country.
Gross National Product (GNP)
• GNP belongs to the nation, and thus, it must be produced by its owned
factors of production only.
• If Ethiopian professor takes up a four month Visiting Professorship in
a US University, his income in USA is the part of Ethiopia's GNP and
similarly the profit that a US company makes in Ethiopia, is not a part
of Ethiopia's GNP
 ............
• The key difference between the two is that GDP is the total output of a
country/region, and GNP is the total output of all nationals of a
country/region.
• GNP= GDP + Net factor income (NFI)/net factor payment (NFP),
where NFI is the income received by domestic factors of production
(Capital and labor) employed abroad minus the income paid to
foreigners employed domestically.
 2.2 Approaches of measuring national income (GDP/GNP)
• There are three main ways of calculating these numbers; the output
approach, the income approach and the expenditure approach.
• In theory, the three must yield the same, because total expenditures on
goods and services (GNE) must equal the total income paid to the
producers (GNI), and that must also equal the total value of the output
of goods and services (GNP).
• However, in practice minor differences are obtained from the various
methods for several reasons, including changes in inventory levels and
errors in the statistics.
• This is because goods in inventory have been produced (therefore
included in GNP), but not yet sold (therefore not yet included in GNE).
• Similar timing issues can also cause a slight discrepancy between the
value of goods produced (GNP) and the payments to the factors that
produced the goods, particularly if inputs are purchased on credit, and
also because wages are collected often after a period of production
 A. The Output approach (final goods vs. the value added) to
measuring GDP
• The product approach defines a nation's gross domestic product (GDP) as the
market value of final goods and services newly produced within a nation during a
fixed period of time.
• In working through the various parts of this definition, we discuss some practical
issues that arise in measuring GDP
i. Market Value
Goods and services are counted in GDP at their market values- that is, at the
prices at which they are sold.
A problem with using market values to measure GDP is that some useful goods
and services are not sold in formal markets.
for example, homemaking and child-rearing services performed within the family
without pay, are not included in GDP.
Some nonmarket goods and services are partially incorporated in official GDP
measures. An example is activities that take place in the so-called underground
 A. The Output approach (final goods vs. the value added) to
measuring GDP
ii. Newly Produced Goods and Services:
As a measure of current economic activity, GDP includes only goods
or services that are newly produced within the current period.
GDP excludes purchases or sales of goods that were produced in
previous periods.
Thus, although the market price paid for a newly constructed house
would be included in GDP, the price paid in the sale of a used house is
not counted in GDP (The value of the used house would have been
included in GDP for the year it was built).
However, the value of the services of the real estate agent involved in
the sale of the used house is part of GDP, because those services are
provided in the current period.
 A. The Output approach (final goods vs. the value added) to
measuring GDP
iii. Final Goods and Services:
• Intermediate vs. final goods
• Intermediate goods (goods used for further production)
• For example, flour that is produced and then used to make bread in the
same year is an intermediate good. The trucking company that delivers
the flour to the bakery provides an intermediate service.
• Final goods (goods that flow for ultimate consumption)
• The value of intermediate goods is not considered in computing
national income since it leads to theproblem of double counting.
..........
 B. The expenditure approach
• There are four main categories of expenditure:
• Personal consumption expenditures (C):household spending on
consumer goods
• Gross private domestic investment (I): spending by firms and
households on new capital, that is, plant, equipment, inventory, and
residential structures, and change in business inventories
• Government consumption and gross investment (G)
• Net exports (EX - IM):net spending by the rest of the world, or exports
(EX) minus imports (IM)
• With these symbols, we express the expenditure approach to measuring
GDP as y = C + I + G + NX
1. Consumption: Consumption is spending by domestic households on
final goods and services, including those produced abroad.
Consumption expenditures are grouped into three categories
 ..........

 Consumer durables, which are long-lived consumer items, such as

cars, televisions, furniture, and major appliances (but not houses,
which are classified under investment);
 Non-durable goods, which are shorter-lived items, such as food,
clothing, and fuel;
 Services, such as education, health care, financial services, and
transportation,
2. Investment: Investment includes both spending for new capital
goods, called fixed investment, and increases in firms' inventory
holdings, called inventory investment. Fixed investment in turn has two
major components:
Business fixed investment,
Residential Investment
 3. Government Purchases of Goods and Services:
• Government purchases of goods and services, which include any expenditure by the
government for a currently produced good or service, foreign or domestic, is the third
major component of spending.
• Not all the checks written by the government are for purchases of goods and services.
• Transfers, a category that includes government payments for Social Security and
Medicare benefits, unemployment insurance, welfare payments, and so on, are
payments (primarily to individuals) by the government that are not made in exchange
for current goods or services.
• As a result, they are excluded from the government purchases category and are not
counted in GDP as calculated by the expenditure approach.
• Similarly, interest payments on the national debt are not counted as part of
government purchases.
4. Net Exports
Net exports are exports minus imports.
Exports are the goods and services produced within a country that are purchased by
foreigners;
 imports are the goods and services produced abroad that are purchased by a country's
 .............
• Exports are the goods and services produced within a country that are purchased
by foreigners;
• imports are the goods and services produced abroad that are purchased by a
country's residents.
• Net exports are positive if exports are greater than imports and negative if
imports exceed exports.
• Exports are added to total spending because they represent spending (by
foreigners) on final goods and services produced in a country.
• Imports are subtracted from total spending because consumption, investment, and
government purchases are defined to include imported goods and services.
• Subtracting imports ensures that total spending, C + I + G + NX, reflects
spending only on output produced in the country.
• For example, an increase in imports may mean that Americans are buying
Japanese cars instead of American cars.
• For fixed total spending by domestic residents, therefore, an increase in imports
lowers spending on domestic production.
.............
 C. The Income Approach to Measuring GDP
• This approach calculates GDP by adding the incomes received by
producers, including profits, and taxes paid to the government.
• A key part of the income approach is a concept known as national
income. National income is the sum of five types of income.
i. Compensation of employees: Compensation of employees is the
income of workers (excluding the self-employed) and includes wages,
salaries, employee benefits (including contributions by employers to
pension plans), and employer contributions to Social Security.
ii. Proprietors’’ income: Proprietors' income is the income of the non-
incorporated self-employed.
• Because many self-employed people own some capital (examples are
a farmer's tractor or a dentist's X-ray machine), proprietors’' income
includes both labor income and capital income.
 .............
iii. Rental income: Rental income of persons, a small item, is the income
earned by individuals who own land or structures that they lent to others.
Some miscellaneous types of income, such as royalty income paid to
authors, recording artists, and others, also are included in this category.
iv. Corporate profits: corporate profits are the profits earned by
corporations and represent the remainder of corporate revenue after wages,
interest, rents, and other costs have been paid.
 Corporate profits are used to pay taxes levied on corporations, such as the
corporate income tax, and to pay dividends to shareholders.
 The rest of corporate profits after taxes and dividends, called retained
earnings, are kept by the corporation.
v. Net interest: Net interest is interest earned by individuals from
businesses and foreign sources minus interest paid by individuals.
In addition to the five components of national income just described,
three other items need to be accounted for to obtain GDP
 ............

• indirect business taxes;

• depreciation; and
• net factor payments
• Indirect business taxes, such as sales and excise taxes are paid by
businesses to governments.
• Indirect business taxes do not appear in any of the five categories of
income discussed, but because they are income to the government,
they must be added to national income to measure all of a country's
income.
• National income plus indirect business taxes equal net national
product (NNP).
• Depreciation (also known as consumption of fixed capital) is the value
of the capital that wears out during the period over which economic
activity is being measured.
 2.3 Other Social Accounts (GNP, NNP, NI, PI and DI)
• To see how the alternative measures of income relate to one another, we start
with GDP and add or subtract various quantities.
• 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 nationals (residents of a nation).
• For instance, if a Japanese resident owns an apartment building in New York, the
rental income he earns is part of U.S. GDP because it is earned in the United
States. But because this rental income is a factor payment to abroad, it is not
part of U.S.GNP. This income is included in the Japan’s GNP and should be
subtracted from the Japan’s GDP
• 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.
National Income (NI)
 Once we subtract indirect business taxes from NNP, we obtain a
measure called national income:
National Income (NI) = NNP-Indirect Business Taxes
National income measures how much everyone in the economy has
earned.
The national income accounts divide national income into five
components, depending on the way the income is earned.
The five categories are:
 ..............

personal income
the amount of income that households and non-corporate businesses
receive.
Thus, personal income is
Personal Income = National Income
− Corporate Profits
− Social Insurance Contributions
− Net Interest
+ Dividends
+ Government Transfers to Individuals
+ Personal Interest Income
 ..............
disposable personal income:
Disposable Personal Income= Personal Income- Personal Tax and
Nontax Payments
We are interested in disposable personal income because it is the
amount households and non-corporate businesses have available to
spend after satisfying their tax obligations to the government.
2.4 Nominal versus Real GDP
Nominal GDP is the Gross Domestic Product of a country of a given
year, estimated on the basis of the price of the goods and services of
the same year.
Real GDP is the Gross Domestic Product of a country of a given year,
estimated on the basis of the price of the goods and services of a
base year.
 Real GDP > Nominal GDP: When the price level of goods and
services in the base year is more than the price level of goods and
services in the current year.
 Real GDP = Nominal GDP: When the price level of goods and
services in the base year is the same as the price level of goods
and services in the current year.
 Real GDP < Nominal GDP: When the price level of goods and
services in the base year is less than the price level of goods and
services in the current year.
Real GDP = (2002 Price of Apples × 2002 Quantity of Apples) + (2002 Price
of Oranges × 2002 Quantity of Oranges).
Similarly, real GDP in 2003 would be Real GDP = (2002 Price of Apples ×
2003 Quantity of Apples) + (2002 Price of Oranges × 2003 Quantity of
Oranges).
And real GDP in 2004 would be Real GDP = (2002 Price of Apples × 2004
Quantity of Apples) + (2002 Price of Oranges × 2004 Quantity of Oranges)
Nominal GDP= (2002 Price of Apples × 2002 Quantity of Apples) + (2002
Price of Oranges × 2002 Quantity of Oranges).
Similarly, Nominal GDP in 2003 would be Nominal GDP = (2003Price of
Apples × 2003 Quantity of Apples) + (2003 Price of Oranges × 2003 Quantity
of Oranges).
And nominal GDP in 2004 would be Real GDP = (2004 Price of Apples ×
2004 Quantity of Apples) + (2004 Price of Oranges × 2004 Quantity of
Oranges)
 2.5 The GDP Deflator and the Consumer Price Index
A. GDP Deflator
• The GDP Deflator for the year yyyy (for a specified base year) is calculated as
follows:
 B. The consumer Price Index (CPI)
• Consumer price index (CPI);Measure of the overall cost of goods & services Bought by a
typical consumer
• CPI is a price index of a particular basket called the CPI-basket.
• The CPI –basket contains basically all the goods and services consumed in a country-
food, gas, medicine, haircuts, transportation, house rent and so on.
• Calculation of the CPI needs a reference or base year for which the CPI is exactly 100
on average.
• How the consumer price index is calculated
• Fix the basket
• Find the prices
• Compute the basket’s cost
• Chose a base year and compute the CPI
• Price of basket of goods & services in current year
• Divided by price of basket in base year
 CPI vs. GDP Deflator
Prices of non-consumer goods and services:
• included in GDP deflator (if produced domestically)
• excluded from CPI
Prices of imported consumer goods and services:
• included in CPI
• excluded from GDP deflator
The basket of goods and services:
• CPI: fixed
• GDP deflator: changes every year
 2.7. The Business Cycle
• The business cycle refers to the period of upward (expansions/boom
in periods of relatively rapid economic growth).
• downward (contractions/recessions in periods of stagnation or
decline) movements in the level of economic activities (GDP) around
its long-term growth trend.
• Business cycles is recurring increases and decreases in the level of
economic activity over periods of time.
• Inflation, growth, and unemployment are related through the business
cycle.
• At a cyclical peak, economic activity is high relative to trend;
• and at a cyclical trough, the low point in economic activity is reached.
Inflation, growth, and unemployment all have clear cyclical patterns.
 Okun’s Law
 A relationship between real growth and changes in the unemployment rate is
known as Okun’s law, named after its discoverer, Arthur Okun.
 Okun’s law says that the unemployment rate declines when growth is above the
trend rate.
 ∆u = -x(ya – yt)
 Where ∆u is change in unemployment, x the magnitude in which unemployment
declines due to a percentage point growth,
 ya actual growth rate of output, and
 yt is trend output growth rate.
 The figure below shows the Okun’s law, relationship between unemployment
and growth in output.
Any questions?