Macroeconomics I-Chapter Two

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 CHAPTER TWO
NATIONAL INCOME ACCOUNTING (NIA)
Why we Learn this Topic?

We are intended to study National Income Accounting for the objectives of:-

Differentiate b/n the d/t approaches of measuring the value of economic activity-measuring
GDP
Differentiate b/n Nominal and Real variables
Describe the business cycle
Distinguish between GDP deflator and consumer price index-CPI
Define and explain macroeconomic variables like Inflation and Unemployment.

INTRODUCTION

A century ago economists had to rely on casual observation as a source of information to

evaluate the performance of an economy and monitor it.
But such casual observations differ from one individual to another making economic policy
making very difficult.
Economists needed some way to combine many individual experiences into coherent whole.
Today, economic data offer a systematic and objective source of information.
One of the data we need which is the single most important measure of overall economic
performance is Gross Domestic Product-GDP.
Hence, in this unit we will discuss about:
the d/t approaches of measuring GDP
the d/c b/n real GDP and nominal GDP
the brief introduction of inflation
unemployment
Consumer price index
GDP deflator and
Business cycle

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2.1. The Concepts of Gross Domestic Product-GDP and Gross National Product-GNP
This is national income accounting-NIA
It involves estimating output or income for the nation or society as a whole
It is not for an individual business firm or family.
The value of a nation’s output equals the total expenditure for this output
That expenditure become the income of those in the nation who have produced this output
It is expressed in terms of either in GNP or GDP
The GDP is an attempt to summarize all economic activity over a period of time in terms of a
single number
It is a measure of the economy’s total output and of total income
Valuing goods at their market price allows us to add d/t goods into a composite measure
We might be misled into thinking we are producing more if prices are rising
In measuring GDP it is important to correct for changes in prices
Economists value goods at the prices at which they sold at some given year-Real GDP
GDP measured at current prices is known as nominal GDP
2.2. Other social accounts (GNP, NNP, NI, and DI)
Two of the most important measure of the overall economy’s performance are:
1. GDP and
2. GNP
a. Gross Domestic Product (GDP):
It is the market monetary value of all final goods and services (G+S) produced in one year
within the boundary of a given country, whether by citizens or foreigners
b. Gross National Products (GNP):
The total market value of all final goods and services (G+S) produced by the nationals
or nationals owned resources in a given time period.
Each good and services produced and brought to market has a price. That price serves as
a measure of value for calculating the total output. Once we know the price of each final
good and service, we can readily calculate the value of output produced in a given time
period.
The total money value of final out put produced each year is our GNP

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 The use of prices to value market output allows us to summarize our output activity and
to compare the output of one period with that of another
GNP accounting can also provide a basis for compassing one country economic
performance with another’s
In other words: GNP=GDP+NFI (Net factor income)
NFI= (Factor Income received from Abroad)-(factor income paid abroad).
GNP may be greater, equal or less than GDP
If NFI>0, then GNP>GDP
If NFI=0, then GNP=GDP
If NFI<0, then GNP<GDP
c. Net National Product (NNP):
NNP is GNP less depreciation.
Depreciation: The consumption of capital goods in the production process, the wearing
out of plant and equipment.
d. National Income (NI):
The total income earned by current factors of production & entrepreneurial ability
NI=NNP-Indirect Business Taxes+ subsidy
e. Personal Income (PI):
Income received by persons or HHs before payment of personal taxes.
That means Personal Income equals National Income (NI) minus social security
insurance, minus corporate income taxes, minus retained earnings, plus transfer payments,
plus net interest.
PI = NI – [social security contribution + corporate income tax + retained corporate
profit] + [Public transfer payments (like Subsidy) + net interest on government bond]
Transfer payments = income received without any good or service provided in return
Examples: social security benefits, unemployment compensation, welfare programs, etc.
f. Disposal Personal Income (DI):
Disposal income is the difference between personal income and personal taxes
That is: DI = PI-PT
DI = C + S
Where, C = personal consumption expenditure
S = Personal savings

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Simple Quiz

Q). The principle difference between GDP and GNP is that GNP measures
______________whereas GDP measures_______________?
A. the value of total output produced in Ethiopia; the total amount of income received by
Ethiopian residents
B. the amount of economic activity within Ethiopia’s economy; the economic activity generated
by the nation’s people
C. the total amount of income received by Ethiopian residents; the value of total output produced
in Ethiopia

D. the estimated value of the total worth of production and services within Ethiopia’s boundary
by its nationals and foreigners; the estimated value of the total worth of production and
services by citizens of Ethiopia on its land or on foreign land

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2.3. Approaches of measuring national income (GDP/GNP)
Three ways of measure GNP/GDP:
1. Product or final goods (value added) approach
2. Expenditure approach and
3. Income or value added approach.
Each approach gives a d/t perspective on the economy
However, all the 3 approaches give identical measurements of the amount of current economic
activity.

National Income Accounting

Product Approach Expenditure approach Income approach

- Agriculture
- Personal expenditure - Wages and salaries

- Manufacturing - Gross private expenditure - Profits

- Government expenditure - Depreciation

- Construction
- Exports - Indirect Business Tax
- Transport
- Imports - Net interest
- Distribution - Rental income

- Bank & insurance

- Health & Education

- etc.

1. The Product Approach:

It measures economic activity by adding the market values of goods and services produced in
all sectors of the economy’.
This approach computes economic activity by summing the values realizes by all sectors

Table 2.1. Final Goods Approach or Value added Approach or Product Approach

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 S.N Economic Sector Value in million USD
1 Agriculture 11670
2 Industry (manufacturing) 11430
3 Mining 890
4 Construction 350
5 Transport and services 435
6 Whole sale trade 80
7 Other services 10.1
8 Government enterprises 500
9 Others 98
10 Net factor income from abroad 8,348

Then 1. GDP_______________? $25,463,100,000

find
2. GNP_______________? $ 33,811,100,000
The most direct way of measuring the National Income is adding up the output figures of
all the firms in the country produced by d/t sectors of the economy.
In this method only the final goods and services are included
I.e. the cost of intermediate goods must be excluded so that Double Counting is avoided.
Double counting arises because the output of some firms are inputs of other firms.
Example: see the below sample

Final value of the cotton output? = sum of value-added by all firms in the economy

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2. Expenditure Approach:
This approach is yet another alternative way of calculating the GDP.
It looks at the demand side of the products.
We add the final expenditure that each buyer in the economy makes.
One man’s income is another man’s expenditure
GDP is thus can be measured by adding all expenditures on final G+S produced in the
country by all sectors of the economy.
GDP (Y) can be estimated by summing up:

A). Personal consumption of HHs (C)

B). Gross private domestic investment (I)

C). Government purchases of G+S (G)

D). Net exports (NE): exports less imports

GDP =Y = C + I + G + NE

No NE term in closed economy policy

Table 2.2. Expenditure Approach

S.N Expenditure categories Million USD

1 Personal Consumption Expenditure (C) 23790
2 Gross Private Domestic Expenditure (I) 865
3 Gov. Purchases of goods & services (G) 608
4 Export (X) 665
5 Import (M) -465
6 Net factor income from abroad 8,348
Then find 1. GDP_______________? $25,463,100,000
2. GNP_______________? $ 33,811,100,000

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 Personal Consumption Expenditure (C):
It includes expenditures by HHs on:-
durable consumer goods (automobiles, televisions, video etc.) and
non-durable consumer goods (foods and others) and
service expenditure (for education, medical care, transport, entertainment… etc)
Gross Private Domestic Investment (I):
all investment spending by business firms like all
final purchases of machinery, equipment and tools by business enterprises;
construction;
changes in business inventories.
Government purchases (spending) on goods and services (G)
It includes all governmental spending on the finished products of business and
All direct purchases of resources, transfer payments and etc.
Exports:
Goods and services purchased by foreign sources.
Imports:
Goods and services purchased from foreign countries.
Net Export:
Is the difference between Exports and Imports i.e.: NX=X-M

GNP=C+I+G+(X-M) + [NFIRA-NFIPA]

3. The Income Approach:

Sums of all income values realized in the economy
Six income structures constitute the GNP/GDP calculated using income approach:
1. Compensation of employees
2. Rent
3. Interest
4. Depreciation
5. Indirect business tax and
6. Profit
Subsidies and transfer payments are deducted from the above incomes

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 Whichever approach that we may follow?
There are 3 major criticisms of the GDP measure:
I. It omits non market goods and services
II. For example Work of stay at home mothers are not included in the GDP measure.
III. It does not account for “bads” such as underground economy.
Crime and pollution.
Example crime is a detriment to society
But there is no subtraction from GDP to account for crime.

Table 2.3. Income Approach

S.N Income Million USD

1 Compensation of employees 12976.8
2 Proprietors’ income (sole proprietor & 1609.6
partnership)
3 Rental income of persons 33.5
4 Corporate profits 1767
5 Net interest 2802.6
6 Depreciation 3454.2
7 Indirect Business Taxes (IBT) 2819.4
8 Net factor income from abroad 8,348
The find
GDP__________________? $25,463,100,000
GNP___________________? $33,811,100,000
o The income approach measures the GNP (GDP) in terms of income earned
o It is the sum of all incomes of all factors of production that contribute to the production
process
o The major components of income are:
I. Compensation of employee (wages and salaries) – W+S
II. Rental income (income earned from land and physical capital) …. R
III. Interest Income ……….. I
IV. Profits (proprietors and corporates) ……. ∏r
V. Indirect Business Taxes such as sales tax, excise tax, business property tax………. IBT
VI. Capital consumption allowance (depreciation) …….. D
o Thus using Income Approach GDP = W+S+R+I+∏+D+IBT

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In a nutshell:

Using Product Approach – GDP = the summation of values realized in all sectors of the
economy
Using the Expenditure Approach - GDP = C+I+G+(X-M)
Using Income Approach GDP = W+S+R+I+∏+D+IBT
2.4. Nominal versus Real GNP

Nominal GNP: The value of final output produced in a given period, measured in the prices of
that period (current prices)

Real GNP: The value of final output produced in a given period, measured in the prices of a base
period (constant prices)

To distinguish increases the quantity of G+S from increases in their prices, we must construct
a measure of GNP that take into account price level changes.
Nominal GNP:
Is the value of G+S measured in that year’s prices
GNP that is not adjusted for inflation
REAL GNP:
Is the value of G+S (output) measured in constant prices
Is simply current-dollar GNP
To calculate REAL GNP, we value G+S at constant prices
Thus the distinction between nominal and real GNP is important whenever the level of prices
change.

REAL GNP = Nominal GNP x 100

CPI
Where CPI = is consumer price Index.

CPI: The device used to estimate the percent change in the prices of a particular bundle of
consumption goods.

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 Example: Suppose a hypothetical nominal GNP of a country be 66 billion dollars in 2000
year and the price index for that year was 110. Calculate the Real GNP for the given year.

Real GNP = Nominal GNP x 100

Price index (GNP deflator)
Real GNP = 66 x 100 = 60 billion dollars
110

A Laspeyers index (L) uses a base year period market basket (for two commodities)

L = P1X0 + P1yY0, Where 0 – value of base year, 1 –value of later year

P0xX0 + P0yY0

The Laspeyers index compares the cost of a basket of goods purchased in some earlier-base-
period with the cost of the same basket in a later year.
The consumer price index is an example of a Laspeyers index.
The cost of the market basket of goods has increased from the base period (0) to time period
(1) if the Laspeyers index (L) has a value greater than one.
Example: Assume that a consumer buys 30 units of good X and 15 units of good Y in the base
period 1990. The price of X equals $8 and the price of Y equals $6 in the base period. If the
2000 prices Px1 = $7 and Py1 = $9, then what is the value of Laspeyers index (L)? and what
does the result implies?
Solution:

L = P1xX0 + P1yY0 = 7x30 + 9x15 = 345 = 1.045

P0xX0 + P0yY0 8x30 6x15 330

- This shows the Laspeyers index (L) will have a value of 1.045
- And again this = 1.045x100-100 = 104.5-100 =4.5%
- The result indicates that the cost of the market basket of goods has increases by 4.5% from
the base period to 2000.

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Per-Capita Income (PCI):

The PCI is a better measurement to compare economic growth across countries

PCI = GNP divided by size of population

Annual Growth Rate = Real GNP (year t) – RGNP (year t-1)

Real GNP (year t-1)

Where, year t – current year

year t-1 – base year

GDP growth Rate = Current GDP – Previous GDP x 100

Previous GDP

Percentage Change = (After-Before x 100)

Before

Example: Suppose that, the gross national product of a country was 2000 million dollars
in 2000 and 2130 million dollars in 2001. Calculate the annual rate of growth of the
economy.
Solution: Real GNP(2001) – Real GNP(2000) x 100

Real GNP (2000)

= 2130-2000 x 100 = 130 x 100 = 6.5%

2000 2000

2.5. The GDP Deflator and the Consumer Price Index

2.5.1. The consumer price index
The cost of almost everything has gone up not only in Ethiopia but in every country of the
world.
This increase in the overall level of prices is called inflation

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 It is one of the primary concerns of economists and policymakers
How economists measure changes in the cost of living is discussed as follows
The most commonly used measure of the level of prices is consumer price index-CPI
The Central Statistical Agency-CSA has the job of computing the CPI
It begins by collecting the prices of thousands of G+S
Just as GDP turns the quantities of many G+S into a single number measuring the value of
production, the CPI turns the prices of many G+S into a single index measuring the overall
level of prices.
The CSA weights d/t items by computing the price of a basket of G+S purchased by a typical
consumer
The CPI is the price of this basket of G+S relative to the price of the same basket in some base
year.
Example: suppose that the typical consumer buys 3 bananas & 2 oranges every month. Then
the basket of goods consists of 3 bananas & 2 oranges, and the CPI is

In this CPI, 2002 is the base year.

The index tells us how much it costs now to buy 3 bananas and 2 oranges relative to how
much it cost to buy the same basket of fruit in 2002.
The CPI is the most closely watched index of prices
But it is not the only such index
Another is the producer price index-PPI
PPI measures the price of a typical basket of goods bought by firms rather than consumers
In addition to these overall price indices, the CSA computes price indices for specific types
of goods, such as food, housing, and energy.
2.5.2. The GDP Deflator
From nominal GDP and real GDP we can compute a third index, the GDP deflator
The GDP deflator also called the implicit price deflator for GDP
The GDP deflator is defined as the ratio of nominal GDP to real GDP times 100.

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 The GDP deflator reflects what is happening to the overall level of prices in the economy.
To better understand this see the next example
Consider again an economy with only one good, banana.
If P is the price of banana and Q is the quantity sold
Then nominal GDP is the total number of birr spent on banana in that year

Nominal GDP =

Real GDP is the number of bananas produced in that year times the price of banana in
some base year

Real GDP = Pbase*Q

The GDP deflator is the price of banana in that
year relative to the price of banana in the base year

P
GDP deflator = Pbase

The definition of the GDP deflator allows us to separate nominal GDP into two parts:
1. One part measures quantities (real GDP) and
2. The other measures prices (the GDP deflator)

That is: Nominal GDP = Real GDP GDP Deflator

Nominal GDP measures the current birr value of the output of the economy
Real GDP measures output valued at constant prices
The GDP deflator measures the price of output relative to its price in the base year
We can also write this equation as

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 In this form the deflator earns its name: it is used to deflate (take inflation out of) nominal GDP
to yield real GDP.
The GDP deflator and the CPI give somewhat d/t information about what is happening to
the overall level of prices in the economy.
There are 3 key d/c b/n the two measures (GDP deflator & the CPI)
I. The first difference:
The GDP deflator measures the prices of all G+S produced
Whereas the CPI measures the prices of only the G+S 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:
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 third and most subtle difference:
Results from the way the two measures aggregate the many prices in the economy
The CPI assigns fixed weights to the prices of d/t goods whereas the GDP deflator
assigns changing weights.
In other words, the CPI is computed using a fixed basket of goods, whereas the GDP
deflator allows the basket of goods to change over time as the composition of GDP
changes.
See the example below which shows how these approaches differ.
Example: suppose that major frosts destroy the nation’s orange crop. The quantity of
oranges produced falls to zero, and the price of the few oranges that remain on grocers’
shelves is driven sky-high. Because oranges are no longer part of GDP, the increase
in the price of oranges does not show up in the GDP deflator. But because the CPI is
computed with a fixed basket of goods that includes oranges, the increase in the price
of oranges causes a substantial rise in the CPI.

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 Economists call a price index with a fixed basket of goods a Laspeyers index
And they call a price index with a changing basket a Paasche index.
Economic theorists have studied the properties of these d/t types of price indices to determine
the better measure of the cost of living.
However neither is clearly superior
When prices of d/t goods are changing by d/t amounts:-
a Laspeyers (fixed basket) index tends to overstate the increase in the cost of living
because it does not take into account that consumers have the opportunity to substitute less
expensive goods for more expensive ones.
By contrast, a Paasche (changing basket) index tends to understate the increase in the cost
of living. Although it accounts for the substitution of alternative goods, it does not reflect
the reduction in consumers’ welfare that may result from such substitutions.
The example of the destroyed orange crop shows the problems with Laspeyers and Paasche
price indices.
Why?
B/s the CPI is a Laspeyers index, it overstates the impact of the increase in orange prices
on consumers: by using a fixed basket of goods, it ignores consumers’ ability to substitute
apples for oranges.
By contrast, b/s the GDP deflator is a Paasche index, it understates the impact on
consumers: the GDP deflator shows no rise in prices, yet surely, the higher price of oranges
makes consumers worse off.
Luckily, the d/c b/c the GDP deflator and the CPI is usually not large in practice.
2.6. The Business Cycle: What is Business Cycle?
It refers to the recurrent up and downs in the level of economic activity that extends over a
period of several years.
It is the natural rise and fall of economic growth over time
Or it is the downward and upward fluctuations of GDP along its natural growth rate over a
long period of time
Inflation, growth, and employment are related through the business cycle.
The economy cycles continuously between growth and contraction.

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 Some periods of growth are greater than others, and some periods of contraction are deeper
than the others are.
The business cycle characterizes with 4 phases
Period of expansion (expansionary/recovery phase)
Peaks (Boom)
Period of contraction (contractionary/recession phase)
Troughs (Depression)

Figure: The Business Cycle

The trend Path of GDP is the path GDP would take if factors of production were fully employed
Over time real GDP changes for two reasons.
I. First, more resources become available which allows the economy to produce more
G+S, resulting in a rising trend level of output.
II. Second, factors are not fully employed all the time.
Thus output can be increased by increasing capacity utilization.
Output is not always at its trend level
The level corresponding to full employment of factors of production.
Rather output fluctuates around the trend level.
Let us see the characteristics of each phases of the business cycle

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 The trough or Depression Phase
It is the economy transitions from the contraction phase to the expansion phase
The low point in economic activity /unemployment is high & output is low
It is when the economy hits bottom/output and employment ‘bottom out’ at their lowest
level
There is an excess amount of unemployment and idle productive capacity
Businesses are more likely to fail because of low demand for their product
Economic expansion/ recovery Phase:-
Expansion phase is b/n the trough/depression and the peak/boom
The economy is growing
Output is increasing
Unemployment reaches its natural rate
The economy’s level of output and employment expand towards full employment
The employment of factors of production increases and that is the source of increased
production
During economic boom/ at a cyclical peak:-
It is the second phase
The highest point b/n end of expansion phase & the start of a contraction phase
It refers to the last month before several key economic indicators, begin to fall
It is at this point that real GDP spending in an economy is its highest level
The economy overheats and there is shortage of labor, parts and materials
National income and national product correspond to a very high degree of utilization of
labor, factories and offices
Demand exceeds production
Inflation is usually present in the peak of economic cycle
The monetary policy could offset the condition and achieve price stability by counter
cyclical action upon money supply.
Contraction or Recession period
Starts at the peak/boom period and ends at the trough
Economic growth weakens, GDP growth falls
When GDP falls to the negative level economists call a recession
Unemployment starts to increase
Output falls with a fall in aggregate demand
Levels of buying, selling, production, and employment typically diminish

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 The most unwelcome stage of the business cycle for business owners and consumers alike
A particularly severe recession is known as a depression
So monetary policy aims at increasing demand
Hence production as well as employment will follow the same pattern of demand
Inflation, growth, and unemployment all have cyclical patterns.
During expansion (recovery) phase the economy expand towards full employment whereas
during a recession/contraction period unemployment increases and less output is produced than
can in fact be produced with the existing resources and technology.
Then there is deviations of output from trend
The deviations 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.
Full employment output is also called potential output.

Output Gap = Potential Output – Actual Output

When looking at the business cycle fluctuation, one question that naturally arises is:
Whether expansion gives way inevitable to old age
or whether they are instead brought to an end by policy mistakes
Often a long expansion reduces unemployment too much; causes inflationary pressures,
and therefore triggers policies to fight inflation-and such policies usually create
recessions.

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Okun’s Law
How Economic growth and unemployment relate?
Because employed workers help to produce G+S and unemployed workers do not
Increases in the unemployment rate should be associated with decreases in real GDP
This 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 ya yt Where,
o u is a change in unemployment
o the magnitude in which unemployment
declines due to a percentage point growth
o y a actual growth rate of output and
o yt is the trend output growth rate

Figure: Below shows the Okun’s law relationship between unemployment and growth in output.

Percentage change
in real GDP

Change in unemployment rate

Figure: Growth and Unemployment Dynamics

Activity

Why do you think expansion of an economy above the trend level gives way to recession?

Hint: Try to relate this with the levels of unemployment and inflationary pressures.

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2.7. Unemployment and Inflation
2.7.1. Unemployment
Unemployment is the macroeconomic problem that affects people most directly and severely
For most people, the loss of a job means a reduced living standard and psychological distress.
Unemployment is a frequent topic of political debate.
Politicians often claim that their proposed policies would help create jobs.
Economists study unemployment to identify its causes and to help improve the p
Some of the public policies that affect the unemployed are:
job-training programs:- assist people in finding employment.
unemployment insurance:- alleviate some of the hardships that the unemployed face.
Laws mandating a high minimum wage: are widely thought to raise unemployment
among the least skilled and experienced members of the labor force.
2.7.1.1. Unemployment Rate:
It is the percentage of total labor force that is currently unemployed
Total unemployment divided by total employment/labor force times 100
Let:-
L denote the labor force
E the number of employed workers
U the number of unemployed workers
Because every worker is either employed or unemployed, the labor force is the sum of the
employed and the unemployed

L=E+U
Rate of Unemployment = U/L
2.7.1.2. What determines the unemployment rate?
To see what determines the unemployment rate:-
we assume that the labor force L is fixed and
focus on the transition of individuals in the labor force b/n employment and
unemployment
This is illustrated as below:-

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 Let:
s denote the rate of job separation:- the fraction of employed individuals who lose their
job each month.
f denote the rate of job finding:- the fraction of unemployed individuals who find a job
each month.
Together, the rate of job separation s and the rate of job finding f determine the rate of
unemployment.
If the unemployment rate is neither rising nor falling
that is, if the labor market is in a steady state
then the number of people finding jobs must equal the number of people losing jobs
The number of people finding jobs is fU and the number of people losing jobs is sE
We can thus write the steady-state condition as:

We can use this equation to find the steady-state unemployment rate.

From an earlier equation:-

the number of employed equals the labor force minus the number of unemployed
Substitute (L − U) for E in the steady-state condition

𝑓𝑈 = 𝑠(𝐿 − 𝑈)

To solving for the unemployment rate, divide both sides of this equation by L

𝑈 𝑠 (𝐿 − 𝑈 )
𝑓 =
𝐿 𝐿
U U
f s 1
L L

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 Now we can solve for U/L as follows:

U U 𝑈 𝑈
f s 1 𝑓 =𝑠−𝑠
L L 𝐿 𝐿

𝑈 𝑈 𝑈 𝑈 𝑠
𝑓 +𝑠 =𝑠 (𝑓 + 𝑠) = 𝑠 =
𝐿 𝐿 𝐿 𝐿 𝑓+𝑠

U s
This equation shows that the steady-state rate of unemployment U/L depends
L s f
on the rates of job separation s and job finding f.

The higher the rate of job separation, the higher the unemployment rate
The higher the rate of job finding, the lower the unemployment rate
This model of the natural rate of unemployment has an obvious but important implication
for public policy.
Any policy aimed at lowering the natural rate of unemployment must either reduce the rate
of job separation or increase the rate of job finding.
Similarly, any policy that affects the rate of job separation or job finding also changes the
natural rate of unemployment.
2.7.1.3. What are the underlying reasons for unemployment?
There are 3 major reasons for unemployment.

I. Frictional unemployment

It takes time to match workers and jobs

The unemployment caused by the time it takes workers to search for a job is called
frictional unemployment.
At any point of time, some workers will be in ‘between jobs’.
That is some workers will be in the process of voluntary switching jobs.
Others will have job connections but will be temporarily laid off b/s of seasonality or
model change occurs.
Workers have d/t preferences and abilities, and jobs have d/t attributes.

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 Besides, the flow of information about job candidates and job vacancies is imperfect, and
the geographic mobility of workers is not instantaneous.
For all these reasons, searching for an appropriate job takes time and effort
And this tends to reduce the rate of job finding.
Indeed b/s d/t jobs require d/t skills and pay d/t wages, unemployed workers may not
accept the first job offer they receive.

II. Structural unemployment

A second reason for unemployment is wage rigidity

the failure of wages to adjust until labor supply equals labor demand.
Sometimes the real wage is stuck above the market-clearing level.
When the real wage is above the level that equilibrates supply and demand, the quantity
of labor supplied exceeds the quantity demanded.
Firms must in some way ration the scarce jobs among workers.
Real-wage rigidity reduces the rate of job finding and raises the level of unemployment.
The unemployment resulting from wage rigidity and job rationing is called structural
unemployment.
Job rationing: is a situation that arises when the real wage rate is above the full
employment equilibrium level
In this case there is a surplus of labor
Workers are unemployed not because they are actively searching for the jobs that best suit
their individual skills but because, at the going wage, the supply of labor exceeds the
demand.
These workers are simply waiting for jobs to become available.
There are three major causes of wage rigidity/Job rationing:
1. Minimum Wage Laws:
Sometimes governments prevent wages from falling to equilibrium level (the level of
wage that clears the market).
This law sets the minimum on the wages that firms pay for their employees in an
attempt to increase the income of the working poor.
Hence, hiring labor force less than a specified wage is illegal

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 2. The monopoly power of unions:
This is a second cause of wage rigidity.
The wages of unionized workers are determined not by the equilibrium of supply and
demand but by collective bargaining between union leaders and firm management.
Often, the final agreement raises the wage above the equilibrium level and allows the
firm to decide how many workers to employ.
Hence, a union wage is generally higher than the equilibrium real wage rate
The result is then:-
a. a reduction in the number of workers hired,
b. a lower rate of job finding and
c. an increase in structural unemployment
A firm may also choose to pay its workers high wages to keep them happy in order to
discourage them from forming a union.
This is because Unions not only raise wages, but also increase the bargaining power of
labor on many other issues such as hours of employment and working conditions.
3. Efficiency Wages:
These constitute a third reason for wage rigidity.
These theories hold that high wages make workers more productive.
The influence of wages on worker efficiency may explain the failure of firms to cut
wages despite an excess supply of labor.
In other words, because a firm operates more efficiently if it pays its workers a high
wage, the firm may find it profitable to keep wages above the level that balances supply
and demand.
The result of this higher-than- equilibrium wage is a lower rate of job finding and
greater unemployment.

III. Cyclical unemployment

A factor of overall unemployment that relates to the cyclical trends in growth and
production that occur within the business cycle is referred to as cyclical unemployment.
When business cycles are at their peak:-
cyclical unemployment will be low b/s total economic output is being maximized

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 When economic output falls as measured by the gross domestic product (GDP):-
the business cycle is low and cyclical unemployment will rise.
Often cyclical unemployment can cause a rise in the natural rate of unemployment.
If young people are out of work for a long time in a recession, it can be difficult to get back
into employment b/s of lack of job experience and decline in motivation.
A concept very much related to cyclical unemployment is full employment.
In macroeconomics, full employment is a condition of the national economy, where all or
nearly all persons willing and able to work at the prevailing wages and working conditions
are able to do so.
It is defined either as absolutely 0% rate of unemployment, as by James Tobin, or as the
level of employment rates when there is no cyclical unemployment.
It is defined by the majority of mainstream economists as being an acceptable level of natural
unemployment above 0%, the discrepancy from 0% being due to non-cyclical types of
unemployment.

Activity
What are the underlying reasons for unemployment? Which reason do you
think best explains the unemployment problem of a developing country?
Hint: Study the causes of the different types of unemployment mentioned in the
above section and this would help you identify the underlying reasons.

2.7.2. Inflation
Inflation is a rising general level of prices.
Inflation has got different kinds of social costs.
Some of the social costs of inflation are:
a. Inflation leads to lower real money balances held by the public.
If people are to hold lower money balances on average, they must make more frequent
trips to the bank to withdraw money.
This inconvenience is referred to as Shoe-leather cost of inflation
This is b/s walking to the bank more often causes one’s shoes to wear out more quickly
b. Inflation induces firms to change their posted prices more often which is also costly.

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 c. The higher the inflation is the greater the variability in relative prices which leads to
microeconomic inefficiencies in the allocation of resources.
d. Inflation arbitrarily redistributes wealth among individuals.
e. It also hurts individuals on fixed pensions.
Various indexes have been devised to measure different aspects of inflation.
Two commonly used indexes are the:
I. Consumer Price Index (CPI) and
II. Producer Price Index (PPI)
The Consumer Price Index (CPI):
Measures inflation as experienced by consumers in their day-to-day living expenses.
The method used to construct the CPI compares the current and base year cost of a basket
of G+S of fixed composition.
For the CPI the base is a fixed "market basket" or bundle of G+S representative of the
purchases of urban consumers.
The index is the ratio of today's cost of the fixed bundle to the base year cost of the same
bundle.
This kind of index implicitly assumes that the consumer's consumption pattern does not
change in response to any price changes.
Producer Price Index (PPI):-
It is the alternative index to the CPI
PPI is an index that measures the average change over time in selling prices by domestic
producers of G+S
PPI measures price change from the perspective of the seller.
There are different types of inflation:
Monetary Inflation:
o According to economist Milton Friedman, "inflation is everywhere and always a monetary
phenomenon."
o In other words, a sharp increase in consumer prices always results from the Treasury
putting money into circulation at a faster rate than the economy is actually creating value.
o "Value" means the actual existing demand for the products within the economy.

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 o Therefore, if there is more money, but not more value, the purchasing power of the currency
will decrease, which manifests itself as a price increase.
Demand-pull inflation:
o Changes in the price level have been attributed to an excess of total demand.
o The business sector cannot respond to this excess demand by expanding real output for the
obvious reason that all available resources are already fully employed.
o Therefore, this excess demand will bid up the price of the fixed real output, causing demand
pull inflation.

Cost push Inflation:

o Inflation may arise on the supply or cost side of the market.
o Unions have considerable control over wage rates.
o They obtain a wage increase.
o Large corporate employers faced now with increased costs but also in the possession of
considerable market power, push their increased wage cost on to consumers by raising the
prices of their production.
Built-in Inflation:
o This is the more abstract concept that inflation also occurs due to past experiences with
inflation.
o Manufacturers assume that inflation will always occur and, in anticipation of this, raise
their nominal prices before the actual value increases, thus creating more inflation on top
of the other types of inflation.
Structural inflation:
o Is due to the change in the structure of total demand.
o This is due to the market power of big business and unions.
o Prices and wages tend to be flexible upward but inflexible downward.
A price index measures the general level of prices in reference to a base year period.
Annual rates of inflation are measured by the percentage change.

Rate of inflation (year t) = CPI yeart – CPI yeart-1 x 100

CPI yeart-1

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Example: In 1992 the market basket price of a commodity was 144.5 birr, in 1993 the same market
basket costs 148.2 birr. Calculate the rate of inflation.
RI (1993) = CPI 1993 – CPI 1992 x 100
CPI 1992
148.2 – 144.5 x 100 = 2.6%
144.5

Macroeconomics I Chapter Two Summary and Exercise

Chapter Summary

o The question of measurement of output comes under the heading of national income
accounting.
o There are three basic approaches to the measurement of the value of the economy’s total output
– the expenditure, the income approach, and the product approach.
o Gross National Product is the value of output produced by factors of production owned by
residents of the country. GNP defers from GDP because some goods made in the country are
produced by foreign – owned factors of production and because our citizens receive income
from abroad, for example, if they own assets abroad.
o Spending on GDP is divided into consumption, investment, government purchases of goods
and services, and net exports.
o Real GDP is the value of the economy’s output measured in the prices of some base year. Real
GDP comparisons provide a better measure of the change in the economy’s physical output
than nominal GDP comparisons, which also reflect inflation.
o The GDP deflator is the ratio of nominal to real GDP. It provides one measure of the rise in
prices from the base rate at which real GDP is valued.

Exercises: A. Discuss the following questions briefly

1. Define the natural rate of unemployment
2. Briefly describe the three types of unemployment that we have discussed in this chapter.
3. Discuss the three types of inflation that we saw in this chapter.
4. Write down some of the limitations of using GDP as an index of welfare of a country.

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 5. The value of the nominal GDP of an economy was 3000 birr in a particular year. The value
of GDP of that country during the same year, evaluated at the prices of some base year, was
6000 birr. Calculate the value of the GDP Deflator of the year in percentage terms. Has the
price level risen between the base year and the year under consideration?
6. We have discussed that CPI and GDP Deflator give different information about the overall
level of prices. Briefly explain the three key differences between the two measures.
7. Draw a diagram that illustrates the business cycle. Now point out the peaks and troughs of
the business cycle. How do these points related to unemployment and inflation.
B. True/ False and explain your answer
1. Transfer payments are included in the government purchases component of aggregate
expenditure.
2. Gross Domestic Product is larger than Net Domestic product.
3. At equilibrium aggregate income equals aggregate expenditure.
4. The market value of all the goods and services produced within a country in a given time
period are included in GDP.

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Computation of GNP

Below are NIA figures for X country

Items Billions of USD

Exports---------------------------------------------------------------------------367

Dividends------------------------------------------------------------------------ 60

Capital consumption allowance--------------------------------------------------307

Wages and salaries------------------------------------------------------------1442

Government purchases of goods and services---------------------------------577

Rents------------------------------------------------------------------------------33

Indirect business taxes----------------------------------------------------------225

Wage and salary supplements---------------------------------------------------280

Gross private domestic investment----------------------------------------------437

Corporate incomes taxes---------------------------------------------------------88

Transfer payments------------------------------------------------------------- 320

Interest-------------------------------------------------------------------------- 201

Proprietors’ income-------------------------------------------------------------- 132

Personal consumption expenditures------------------------------------------ 1810

Imports-------------------------------------------------------------------------- 338

Social security contributions----------------------------------------------------148

Undistributed corporate profits--------------------------------------------------55

Personal taxes--------------------------------------------------------------------372

Compute each of the following

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 a) Compensation of employees

b) Net exports

c) Net private domestic investment

d) Compute the GDP using expenditure and income approach

e) find the Net national product

f) National income

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