COMBINED MACROECONOMICS FOR AcFN STUDENTS

CHAPTER ONE

1. Introduction

1.1. Introduction to Macroeconomics

1.1.1. Discussion of Basic Concepts

Economics is the study of economies and the behaviour of economic agents in them. The subject matter
of economics is conventionally divided into two branches known as microeconomics and
macroeconomics. This distinction is important because, though they are related, the problems
considered in the two branches are different. Their methods of analysis are also different.

Microeconomics deals with ‘parts’ of the economy; it takes sectoral view rather than a general view of
economic activities. In microeconomics we are largely concerned with individual markets and the
individual economic agents in these markets such as consumers and firms. Analysis in this branch of
economics deals with such matters as:

• The determination of the prices of particular commodities.

• The output, wage and employment level of individual firms and industries.

• The income of individuals, etc.

Macroeconomics, on the other hand, deals with an economy in its totality. In this branch of economics
we study the behaviour of aggregates rather than the parts of the economy; it goes beyond the
determination of prices in particular markets and deals with the market for goods as a whole, treating all
markets as a single market. Similarly, it deals with the labour market as a whole, abstracting from the
differences between the markets for, say, unskilled daily labour and engineers. Generally,
macroeconomics concerns itself with:

• The level and rate of growth of national level of output.

• The general price level and fluctuations in price levels (inflation and deflation).

• The level of national un/employment, investment, wage and economic growth.

It is important to note, however, that microeconomics and macroeconomics are related in that it is
necessary to understand the parts, if one is to understand the whole.

1.1.2. Definition and Scope of Macroeconomics

Macroeconomics is broadly defined as ‘a branch of economics that deals not with individual quantities
as such, but with aggregates of the quantities; not with individual incomes but with national income; not
with individual prices, but with price level; not with individual outputs but with national output’ by
Boulding.

The broad problems which form the scope of Macroeconomics are related to:

 Fluctuations in the level of employment of labour and general level of money wage.
 Fluctuations in average prices.

 Allocation of resources between consumer and capital goods and their productivity.

 The relation between international trade and the level of employment, prices and growth of the
domestic economy.

1.1.3. Tools of Analysis for the difference between Microeconomics and Macroeconomics

‘Micro’ means small, hence microeconomics means ‘the economy in small’ which deals with single
economic units. On the other hand, ‘Macro’ means very large, hence macroeconomics means ‘the
economy in large’ which deals with the economy as a whole and focuses on the utilization of resources,
particularly level of employment and general level of prices. In general, microeconomics and
macroeconomics can be easily distinguished on the basis of their approach, method of analysis and
degree of aggregation.

 Approach: microeconomics studies the problems of each of the constituents of circular flow of
income like households, firms and markets while macroeconomics studies the overall behaviour of the
circular flow.

 Method of Analysis: in microeconomics the analysis conceives equilibrium between demand and
supply in a single commodity market while in macroeconomics the analysis conceives equilibrium
between demand and supply in the economy as a whole. Here, since using physical quantities is
impossible money value of commodities is taken. Both make extensive use of demand and supply
analysis. But they have differences on how markets work. Microeconomics assumes that imbalances
between demand and supply are resolved by changes in price. Rises in price bring forth additional
supply, and falls in prices bring forth additional demand, until supply and demand are once again in
balance. Macroeconomics considers the possibility that imbalances between supply and demand can be
resolved by changes in quantities rather than in prices. That is, businesses may be slow to change the
prices they charge, preferring instead to expand or contract production until supply balances demand.

 Degree of aggregation: both microeconomics and macroeconomics deal with demand and
supply. The only difference being the degree. The degree of aggregation is higher in macroeconomics. In
addition, microeconomics is the application of partial equilibrium analysis while macroeconomics
employs the quasi-general equilibrium analysis.

1.2. Evolution and Developments in Macroeconomics

Macroeconomic thinking is believed to be originated from four main sources in the early periods. These
are:

 The concept of circular flow of payments: it refers to the flow of real and financial resources in
the economy.

 The concept of national income: it refers to the value of total output the country produces
within its territory each year.

 The concept of Value of money: it refers to the measurement of the value of goods and services
in common standards.
 The concept of trade cycle: it refers to the path through which the economy makes its
movement over time.

Once originated from these ideas, macroeconomics had passed through different stages of
development- known as schools of economic thoughts. They mainly differ on the basis of whether
government intervention is required for the better functioning of the economy or not.

Up to the end of the 19th century it was generally assumed that government intervention in the working
of the economic system should be kept to the minimum. Any official intervention with the free play of
market forces would only be harmful to economic development. This view stems from Britain’s success
in developing the world’s greatest industrial power on the basis of private enterprise. Accordingly, the
government’s role was limited to maintaining peace and security and creating a framework of rules and
regulations which would assist the operation of free markets.

During the 20th century there has been a remarkable change of public opinion. The successful control of
national resources by states and the heavy and chronic unemployment during World Wars I and II led to
the rejection of the ideas that market forces should be left unhindered and that governments should not
play an active role in determining the course of economic development. During the inter-war period
governments were compelled to take some positive actions to deal with unemployment. Domestic
industries were protected, some industries were given assistance etc. These efforts resulted in
significant drop in unemployment in the late 1930s.

In relation to the role of the government in the economy, the different schools of thought are:

 Classical school (1776-1870): In this period, the distinction between microeconomics and
macroeconomics was not clear. The ruling principle was the ‘invisible hand’ coined by Adam Smith. This
period was characterized by absence of government intervention in the operation of markets, which
was a result of the general conception of the time that markets operate best when left by themselves.
There was a period that immediately follows the classical period known as -Neo classical school (1870-
1936). There is no basic difference between classical school and neoclassical school. The main difference
lies in the tool of analysis they make use of. Neo classical school introduced the concept of marginal
analysis and the mathematics with which to execute it, while the classical school depended mainly on
demand and supply analysis.

The new classical macroeconomics remained influential in the 1980s. It sees the world as one in which
individuals act rationally in their self interest in markets that adjust rapidly to changing conditions. The
government, it is claimed, is likely only to make things worse by intervening.

The central working assumptions of the new classical school are three:

• Economic agents maximize: Households and firms make optimal decisions given all available
information in reaching decisions and that those decisions are the best possible in the circumstances in
which they find themselves.

• Expectations are rational: which means they are statistically the best predictions of the future
that can be made using the available information. Rational expectations imply that people will
eventually come to understand whatever government policy used, and thus that it is not possible to fool
most of the people all the time or even most of the time.
• Markets clear: there is no reason why firms or workers would not adjust wages or prices if that
would make them better off. Accordingly, prices and wages adjust in order to equate supply and
demand; in other words markets clear. For instance, any unemployed person who really wants a job will
offer to cut his wages until the wage is low enough to attract an offer from some employer. Similarly,
anyone with an excess supply of goods will cut prices so as to sell. The essence of the new classical
school is the assumption that markets are continuously in equilibrium.

 Keynesian school (1936-1970): The great depression of the 1930s compelled economists to
recommend government intervention to improve the economic condition. This was a radical shift of
attitude compared to the general thought of the time. The economist who first proposed government
intervention was John Maynard Keynes, and accordingly this view is regarded as Keynesian view. The
main thesis of Keynes’s model is that because of failure of the system, as is the case in the 1930s, the
economy may not achieve full employment level, this makes government intervention inevitable.

In a very simplified form we can present Keynes’s theory of recessions. Imagine an economy that is
operating at full employment level of resources. Alongside the smoothly functioning ‘real’ economy,
there will be a smooth financial flows as firms earn money from their sales, pay out their earnings in
wages and dividends, and households spend these receipts on new purchases from the firms.

But now suppose that for some reason each household and firm in this economy decides that it would
like to hold a little more cash. Keynes argued, in particular, this happens when businessmen lose
confidence and start to think of potential investments as risky leading them to hesitate and accumulate
cash instead; today we might add the problem of nervous households who worry about their jobs and
cut back on purchases of big-ticket consumer items. Either way, each individual firm or household tries
to increase its holdings of cash by cutting its spending so that its receipts exceed its outlays.

As Keynes pointed out, what works for an individual does not work for the economy as a whole, because
the amount of cash in the economy is fixed. An individual can increase his cash holding by spending less,
but s/he does so only by taking away cash that other people had been holding. Obviously, not everybody
can do this at the same time. So what happens when everyone tries to accumulate cash simultaneously?

The answer is that income falls along with spending. One try to accumulate cash by reducing his/her
purchases from others, and others try to accumulate cash by reducing their purchases from him/her; the
result is that both incomes fall along with their spending and neither of them succeeds in increasing
their cash holdings.

If they remain determined to hold more cash, they will react to this disappointment by cutting their
spending still further, with the same disappointing result; and so on and so on. Looking at the economy
as a whole, you will see factories closing, workers laid off, stores empty, as firms and households
throughout the economy cut back on spending in a collectively vain effort to accumulate more cash, the
process only reaches a limit when incomes are so shrunken that the demand for cash falls to equal the
available supply.

For Keynes to do about recessions, the first and most obvious thing to do is to make it possible for
people to satisfy their demand for more cash without cutting their spending, preventing the downward
spiral of shrinking spending and shrinking income. The way to do this is simple, to print more money and
somehow get it into circulation.
So the usual and basic Keynesian answer to recessions is a monetary expansion. But Keynes worried that
even this might sometimes not be enough, particularly if a recession had been allowed to get out of
hand and become a true depression. Once the economy is deeply depressed, households and especially
firms may be unwilling to increase spending no matter how much cash they have; they may simply add
any monetary expansion to their hoarding. Such a situation, in which monetary policy has become
ineffective, has come to be known as a “liquidity trap”. In such a case, the government has to do what
the private sector will not: spend. When monetary expansion is ineffective, fiscal expansion must take its
place. Such a fiscal expansion can break the vicious circle of low spending and low incomes and getting
the economy moving again.

The new classical group remains highly influential in today’s macroeconomics. But a new generation of
scholars, the new Keynesians, mostly trained in the Keynesian tradition but moving beyond it, emerged
in the 1980s. They do not believe that markets clear all the time; but seek to understand and explain
exactly why markets fail.

The new Keynesians argue that markets sometimes do not clear even when individuals are looking out
for their own interests. Both information problems and costs of changing prices lead to some price
rigidities, which help cause macroeconomic fluctuations in output and employment. For example, in the
labour market, firms that cut wages not only reduce the cost of labour but are likely to wind up with a
poorer quality labour. Thus, they will be reluctant to cut wages.

 Period of Quantitative Analysis (1970s-present): During this period there has been no dominant
school of thought in macroeconomics. However, the period is characterized by the huge application of
statistical and mathematical methods for rather than logical reasoning economic analysis. Different
economic views have been used in different economies under different circumstances.

Monetarism, as advocates of free market, started challenging Keynes’s theory in the 1970s. Milton
Friedman, the founder of monetarism attacked Keynes’s idea of smoothing business cycle on the ground
that such active policy is not only unnecessary but actually harmful, worsening the very economic
instability that it is supposed to correct and should be replaced by simple, mechanical monetary rules.
This is the doctrine that came to be known as “monetarism”.

Friedman began with a factual claim: most recessions including the huge slump that initiated the Great
Depression, did not follow Keynes’s script. That is, they did not arise because the private sector was
trying to increase its holdings of a fixed amount of money. Rather, they occurred because of a fall in the
quantity of money in circulation.

If economic slumps begin when people spontaneously decide to increase their money holdings, then the
monetary authority must monitor the economy and pump money in when it finds a slump is imminent.
If such slumps are always created by a fall in the quantity of money, then the monetary authority need
not monitor the economy; it needs only make sure that the quantity of money doesn’t slump. In other
words, a straight forward rule– “keep the money supply steady” is good enough, so that there is no
needs for a “discretionary” policy of the form “pump money in when your economic advisers think a
recession is imminent”.

All schools of macroeconomics agree on the purpose of macro policy but they disagree on how to
achieve the macro objectives of higher output, lower level of unemployment and inflation.
The Aims of Government Policy

A government’s economic policy objectives can be classified under five headings.

Internal Balance: it refers to full employment and stable price. It is generally held that the main objective
of government economic policy is maintaining the demand for labour at a high level so that there is full
employment of the labour force. This does not mean that everyone willing to work will always be in
employment. There are serious imperfections in the labour market. Owing to the immobility of labour, it
is possible for large numbers of people to be out of work even when there are many vacancies.
Fluctuations in the general level of prices, on the other hand, can cause harmful distortions in debtor-
creditor relationships, the balance of payments situation, and the level of production and the
distribution of real income. For example, a rapid increase in prices will reduce the purchasing power of
savings; it will reduce the real burdens of debts so that debtors repay less in real terms than they
borrowed; it will increase the prices of exports and make them less attractive to foreigners, and it will
reduce the real income of those on fixed money incomes, relative to those whose incomes are rapidly
adjusted to the changing price level. Governments will be concerned to eliminate or reduce such
harmful developments.

External Balance: what is a satisfactory balance of payments depends on the situation a country finds
itself. If the government has adequate foreign currency reserves and can borrow from other countries it
may allow a series of deficits to develop while imports are rising faster than exports, as a necessary part
of a policy to stimulate economic growth. In the longer run, however, a country’s exports earning must
balance its payments to other countries.

Acceptable rate of economic growth: in all developed and developing countries there is always a desire
for a better living condition. Such insistent demands for higher standard of living have forced
governments to give a high priority to policies which will bring about a steady increase in output per
head.

Redistribution of income and wealth: general dissatisfaction with the extremely unequal distribution of
income and wealth brought about by the uncontrolled operation of market forces has obliged
governments to adopt policies designed to reduce these inequalities. A system of taxation which bears
more heavily on those with higher incomes and more wealth together with government spending on a
wide range of social services which provide important supplements to the real incomes of the poor
members of society are major features of economic policy.

The Instruments of Government Economic Policy

In order to carry out economic policies states may intervene in the operation of the economy in three
main ways.

Fiscal policy: this is a deliberate manipulation of government income and expenditure with a view to
influencing income, output, employment and prices. The state is by far the biggest business in most
developed economies and variation in its spending will have an important influence on total demand.
Similarly, changes in taxation will affect both the total of private expenditure and its distribution on
various goods and services. In an inflationary situation, for example, where total demand exceeds total
supply at current prices, the government may reduce its own spending and increase the rates of taxation
on income and expenditure.
Monetary policy: the government is able to control the total money supply through central banks,
National Bank of Ethiopia in our case. Total expenditure on goods and services may be increased or
decreased by variations in the supply of money and in terms of which it may be borrowed (i.e. the rate
of interest). The greater part of the money supply consists of bank credit (i.e. bank deposits), and
monetary policy aims to vary both the quantity and the price of such credit.

Direct controls: the state has the powers, if it wishes to use them, to institute a vast range of physical
controls on the economic system. It has the political power to bring the means of production (land and
capital) into public ownership and to decide the volume and pattern of production independently of
market forces. This would call for detailed central planning so that the planned outputs of the different
sectors of the economy could be dovetailed together.

The Incompatibility of Objectives

The conduct of economic policy is a most difficult task because, so often, the principal objectives of that
policy are mutually incompatible. If governments had to pursue only one of the aims above without
having to worry about the other targets, there would be relatively few problems of economic policy.
Unfortunately, this is not the case. An attempt to achieve a faster rate of economic growth, for example,
might lead to a large increase in the imports of basic materials, fuel and machinery, which might well
put the balance of payments account into deficit. When there are inflationary tendencies, the pursuit of
price stability might require the use of measures to reduce total demand. But these same measures
could well result in a reduction of output rather than prices, so that unemployment increases. The
government will find itself having to compromise – to balance one objective against another. Economic
policy will have to be cast in terms of priorities, which themselves will change over time. Some degree of
inflation might be the price which has to be paid for maintaining a high level of employment; some curb
may have to be placed on the planned rate of economic growth in order to achieve acceptable balance
of payments equilibrium and so on.

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CHAPTER TWO

2. National Income Accounting

2.1. Measurements National Income Accounting

National Income is defined differently by different economist. In connection let us see different views
adopted by different economists to define national income. These are:

 The Traditional view

 The Keynesian view

 The Modern view

In the traditional view, national income is defined as follows:

''The national income or dividend consists solely of services as received by ultimate consumers, whether
from their material or from their human environment '' Fisher I. From this definition, the economist
adopts consumption as the basis of national income. But it is not an easy task to measure net
consumption and the value of services rendered by consumer durables year after year.

''The labour and capital of country acting on its natural resources produce annually a certain net
aggregate of commodities, material and immaterial, including services of all kind. This is the true net
national income or revenue of the country or national dividend'' Marshal A. According to him, it means
that all types of goods and services which are produced, whether they are brought to the market or not,
are included in the national income. He added that the cost of wear and tear of the machinery should be
deducted from the total value of these goods and services. He also took in account income from abroad
while calculating the national income.

''National income is that part of the objective income of the commodity, including of course, income
derived from abroad which can be measured in money'' Pigou. It means that only goods and services
exchanged for money are included in the national income.

In the Keynesian view, national income is defined with respect to three approaches:

• The Expenditure Approach: here, national income is equal to total consumption expenditure and
total investment expenditure systematically i.e. Y=C+I where Y is national income, C is consumption
expenditure and I is total investment expenditure

• The Income Approach: here national includes the total income of all factors of production i.e.
Y=F+EP where Y refers to national income, F is the payments received by owners of factors of production
and EP is entrepreneurial profits.

• Sale minus Cost Approach: in this approach national income(Y) is equal to total sales of proceeds
(A) less user cost (U) i.e. Y=A-U

In the modern view any of the following three approaches may be used to determine national income of
a country namely; product approach, income approach or expenditure approach.

In this course, the modern approaches are discussed in detail with the help of numerical examples in the
next section. In all cases, however, two measurements of national income are discussed. These are gross
domestic product and gross national product.

Gross domestic product [GDP] is often considered the best measure of how well the economy is
performing. The goal of GDP is to summarize in a single number the monetary value of economic
activities in a given period of time.

Definition: Gross Domestic Product (GDP) is the market value of all final goods and services produced
within an economy in a given period of time.

There are two ways to view this statistic. One way to view GDP is as the total income of everyone in the
economy. Another way to view GDP is as the total expenditure on the economy’s output of goods and
services. From either viewpoint, it is clear why GDP is a measure of economic performance. GDP
measures something people care about – their incomes. Similarly, an economy with a large output of
goods and services can better satisfy the demands of households, firms, and the government.

How can GDP measure both the economy’s income and the expenditure on its output? The reason is
that these two quantities are really the same: for the economy as a whole, income must equal
expenditure. That fact, in turn, follows from an even more fundamental one: because every transaction
has both a buyer and a seller, every Birr of expenditure by a buyer must become a Birr of income to a
seller. When Abebe paints Kebede’s house for Birr 1,000, that Birr 1,000 is income to Abebe and
expenditure by Kebede. The transaction contributes Birr 1,000 to GDP, regardless of whether we are
adding up all income or adding up all expenditure.

Imagine an economy that produces single good, bread, from a single input, labour. The Figure below
illustrates all the economic transactions that occur between households and firms in this economy.

The inner circle in the Figure represents the flows of bread and labour. The households sell their labour
to the firms. The firms use the labour of their workers to produce bread, which the firms in turn sell to
the households. Hence, labour flows from households to firms, and bread flows from firms to
households. The outer circle represents the corresponding flow of money. The households buy bread
from the firms. The firms use some of the revenue from these sales to pay the wages of their workers,
and the remainder is the profit belonging to the owners of the firms (who themselves are part of the
household sector). Hence, expenditure on bread flows from households to firms, and income in the form
of wages and profit flows from firms to households.

GDP measures the flow of money in this economy. To compute GDP, we can look at either the flow of
money from firms to households or the flow of money from households to firms. Every transaction that
affects expenditure must affect income, and every transaction that affects income must affect
expenditure.

For example, suppose that a firm produces and sells one more loaf of bread to a household. Clearly this
transaction raises total expenditure on bread, but it also has an equal effect on total income. If the firm
produces the extra loaf without hiring any more labour (such as by making the production process more
efficient), then profit increases. If the firm produces the extra loaf by hiring more labour, then wages
increase. In both cases, expenditure and income increase equally.

Gross National Product [GNP] is, on the other hand, defined as the value of goods and services produced
by nationals (citizens) of a country.

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 Receipts From Abroad - Factor Payments to Abroad.

GNP = GDP + Net Factor Income.

GNP measures the total income earned by nationals (residents of a nation), while GDP measures the
total income produced domestically. For instance, if an Indian resident owns an apartment building in
Addis Ababa, the rental income he earns is part of Ethiopian GDP because it is earned in the Ethiopia.
But because this rental income is a factor payment to abroad, it is not part of Ethiopian GNP. In Ethiopia,
factor receipts from abroad are less than factor payments to abroad; this leaves the net factor payments
negative. As a result of this, GDP is higher than GNP.

2.1. Approaches to National Income Accounting Process

Rules for Computing GDP

1. Used Goods

GDP measures the value of currently produced goods and services. The sale of used goods reflects the
transfer of an asset, not an addition to the economy’s income. Thus, the sale of used goods is not
included as part of GDP. For example, if Rahel sells her domestically produced old TV set to her fried
Liya; such transactions represent the transfer of this asset from Rahel to Liya and transfer of money
from Liya to Rahel. The value of the old TV set represents value produced in the past. It is, therefore,
omitted in measuring GDP.

2. The Treatment of Inventories

The goods and services produced in an economy may not be sold in the year they are produced. Instead,
they are put into inventory to be sold later. In this case, the owners of the firm are assumed to have
“purchased’’ the goods for the firm’s inventory, and the firm’s profit is not reduced by the additional
wages it has paid to produce the goods. Because the higher wages raise total income, and greater
spending on inventory raises total expenditure, the economy’s GDP rises.

What happens later when the firm sells the goods out of inventory? This case is much like the sale of a
used good. There is spending by consumers, but there is inventory disinvestment by the firm. This
negative spending by the firm offsets the positive spending by consumers, so the sale out of inventory
does not affect GDP. The general rule is that when a firm increases its inventory of goods, this
investment in inventory is counted as expenditure by the firm owners. Thus, production for inventory
increases GDP just as much as production for final sale. A sale out of inventory, however, is a
combination of positive spending (the purchase) and negative spending (inventory disinvestment), so it
does not influence GDP. This treatment of inventories ensures that GDP reflects the economy’s current
production of goods and services.

3. Intermediate Goods and Value Added

Many goods are produced in stages: raw materials are processed into intermediate goods by one firm
and then sold to another firm for final processing. How should we treat such products when computing
GDP? For example, a flour mill sells flour for Birr 350 to a baker who produces 1000 loafs of bread and
sells each loaf of bread for Birr 0.50. Should GDP include the value of flour and bread or only the value of
bread?

The answer is that GDP includes only the value of final goods. Thus, the bread is included in GDP but the
flour is not: GDP increases by Birr 500 (Birr 0.50×1000), not by Birr 850. The reason is that the value of
intermediate goods is already included as part of the market price of the final goods in which they are
used. To add the intermediate goods to the final goods would be double counting – that is, the flour
would be counted twice. Hence, GDP is the total value of final goods and services produced.
One way to compute the value of all final goods and services is to sum the value added at each stage of
production. The value added of a firm equals the value of the firm’s output less the value of the
intermediate goods that the firm purchases. In the case of the bread, the value added of the flour mill is
Birr 350 and the value added of the baker is Birr 150 (Birr 500 – Birr 350). Total value added is Birr 350 +
Birr 150, which equals Birr 500. For the economy as a whole, the sum of all values added must equal the
value of all final goods and services. Hence, GDP is also the total value added of all firms in the economy.

4. Housing Services and Other Imputations

Although most goods and services are valued at their market prices when computing GDP, some are not
sold in the marketplace and therefore do not have market prices. If GDP is to include the value of these
goods and services, we must use an estimate of their value. Such an estimate is called an imputed value.

Imputations are especially important for determining the value of housing. A person who rents a house
is buying housing services and providing income for the landlord; the rent is part of GDP, both as
expenditure by the renter and as income for the landlord. Many people, however, live in their own
homes. Although they do not pay rent to a landlord, they are enjoying housing services similar to those
that renters purchase. To take account of the housing services enjoyed by homeowners, GDP includes
the “rent’’ that these homeowners “pay’’ to themselves. Of course, homeowners do not in fact pay
themselves this rent. The relevant government agencies estimate what the market rent for a house
would be if it were rented and includes that imputed rent as part of GDP. This imputed rent is included
both in the homeowner’s expenditure and in the homeowner’s income.

Imputations also arise in valuing government services. For example, police officers and fire-fighters
provide services to the public. Giving a value to these services is difficult because they are not sold in a
marketplace and therefore do not have a market price. The national income accounts include these
services in GDP by valuing them at their cost. That is, the wages of these public servants are used as a
measure of the value of their output. In addition, some of the output of the economy is produced and
consumed at home and never enters the marketplace. For example, meals cooked at home are similar
to meals cooked at a restaurant, yet the value added in meals at home is left out of GDP.

2.2.1. The Output Approach

This is a method of measuring gross national product by adding up the market value of output of all
firms in the country. In this method of measuring gross national product, it is important include only
final goods and services in order to avoid double counting. Double counting arises when the output of
some firms are used as the inputs of other firms. There are two ways of avoiding this problem. These
are; taking only the value of final goods and services or taking the sum of the added value of firms at
different stages of production. The following table shows how the total output of the economy is
determined for Ethiopia.

Sectors Value of Output (in million Birr)

1) Primary Sector
a) Agriculture 33559.92

b) Forestry 2664.03

c) Fishing 1146.73

Subtotal 37365.68

2) Secondary Sector

a) LMS Industries 5743.24

b) Construction 4566.92

c) Electricity and Water 456.69

d) Mining 304.46

Subtotal 11071.31

3) Territory Sector

a) Banking and Insurance 16399.38

b) Education 2283.46

c) Health 1037.94

d) Defence 415.17

e) Other Service 622.76

Subtotal 20758.71

Gross Domestic Product 69195.70

4) Net Income from Abroad (9195.70)

Gross National Income 60000.00

2.2.2. The Expenditure Approach

Economists and policymakers care not only about the economy’s total output of goods and services but
also about the allocation of this output among alternative uses. The national income accounts divide
GDP into four broad categories of spending:

• Consumption (C)

• Investment (I )

• Government purchases (G)

• Net exports (NX).

Thus, letting Y stand for GDP,

Y = C + I + G + NX.

GDP is the sum of consumption, investment, government purchases, and net exports. Each dollar of GDP
falls into one of these categories. This equation is an identity – an equation that must hold because of
the way the variables are defined. It is called the national income accounts identity.

Consumption consists of the goods and services bought by households. It is divided into three
subcategories: nondurable goods, durable goods, and services.

Investment consists of goods bought for future use. Investment is also divided into three subcategories:
business fixed investment, residential fixed investment, and inventory investment. Business fixed
investment is the purchase of new plant and equipment by firms. Residential investment is the purchase
of new housing by households and landlords. Inventory investment is the increase in firms’ inventories
of goods (if inventories are falling, inventory investment is negative).

Government purchases are the goods and services bought by federal, state, and local governments. This
category includes such items as military equipment, highways, and the services that government
workers provide. It does not include transfer payments to individuals, such as Social Security and
welfare. Because transfer payments reallocate existing income and are not made in exchange for goods
and services, they are not part of GDP.

The last category, net exports, takes into account trade with other countries. Net exports are the value
of goods and services exported to other countries minus the value of goods and services that foreigners
provide us. Net exports represent the net expenditure from abroad on our goods and services, which
provides income for domestic producers. The following example helps you know how to calculate
GDP/GNP using the expenditure approach.

Expenditure Components Value (in million Birr)

1) Consumption Expenditure 52192.9

2) Gross Investment Expenditure 21548.7

Less Depreciation 5904.4

15644.3

3) Government Purchases 15052.5

4) Exports 5232.6

5) Imports18926.6

13694.0

Gross Domestic Product 69195.70

6) Income to Foreigners 14769.5

7) Income to Nationals 5573.8

(9195.7)

Gross National Income 60000.00

Source: MoFED.

2.2.3. The Income Approach

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, and the percentage of national income paid in each category, are

• Compensation of employees: The wages and fringe benefits earned by workers.

• Proprietors’ income: The income of non-corporate businesses, such as small farms, and law
partnerships.

• Rental income: The income that landlords receive, including the imputed rent that homeowners
“pay’’ to themselves, less expenses, such as depreciation.

• Corporate profits: The income of corporations after payments to their workers and creditors.

• Net interest: The interest domestic businesses pay minus the interest they receive, plus interest
earned from foreigners.

• Depreciation (Capital Consumption Allowance) (D): the annual payment, which estimates the
amount of capital equipment used up in each year's production, is called depreciation. It represents a
portion of GNP that must be used to replace the machinery and equipment used up in the production
process.

• Indirect Business Tax (IBT): the government imposes indirect taxes on business firms. These
taxes are treated as cost of production. Therefore, business firms add these taxes to the prices of the
products they sell. Indirect business tax includes sales taxes, excise taxes and custom duties. The
following example helps you know how to calculate GDP/GNP using the income approach.

Types of Income Value (in million Birr)

1) Compensation of Employees 45623.71

2) Rental Income 1249.32

3) Proprietor’s Income 10561.21

4) Corporate Profits 16960.33

Subtotal 27521.54

5) Net interest 5189.73

6) Depreciation 521.84

7) Indirect Business Taxes 476.51

8) Subsidy 11368.95

Gross Domestic Product 69195.70

9) Income from abroad 2036.20

10) Payments to abroad 11231.90

(9195.70)

Gross National Income 60000.00

Other Measures of Income

Other measures of national income include Net National Product (NNP), National Income (NI), Personal
Income (PI) and Personal Disposable Income (PDI).

1. To obtain net national product (NNP), we subtract the depreciation of capital – the amount of
the economy’s stock of plants, equipment, and residential structures that wears out during the year:

NNP = GNP - Depreciation.

In the national income accounts, depreciation is called the consumption of fixed capital. Because the
depreciation of capital is a cost of producing the output of the economy, subtracting depreciation shows
the net result of economic activity.

2. National Income (NI): the next adjustment in the national income accounts is for indirect
business taxes, such as sales taxes. These taxes, place a wedge between the price that consumers pay
for a good and the price that firms receive. Because firms never receive this tax wedge, it is not part of
their income. Once we subtract indirect business taxes from NNP, we obtain national income.

National Income = NNP - Indirect Business Taxes + Subsidy

3. Personal Income: national income, however, is not that income households and non-corporate
businesses receive. The amount of income received by households and non-corporate businesses is
called personal income. In order to find personal income, first, we reduce national income by the
amount that corporations earn but do not pay out (retained earnings and corporate taxes). This
adjustment is made by subtracting corporate taxes and retained earnings. Second, we increase national
income by the net amount the government pays out in transfer payments. This adjustment equals
government’s transfers to individuals minus social insurance contributions paid to the government.
Third, we adjust national income to include the interest that households earn rather than the interest
that businesses pay. This is because; part of the interest that businesses pay goes as interest on
government debts. Thus, personal income is
Personal Income = National Income - Corporate Profits

- Social Insurance Contributions

- Net Interest

+ Dividends

+ Government Transfers to Individuals

+ Personal Interest Income

4. Personal Disposable Income (PDI): is the amount of income households use for either direct
consumption or saving. It is calculated as the difference between Personal Income and Personal Income
taxes such as income taxes, property taxes and inheritance taxes.

Personal Disposable Income (PDI) = Personal Income (PI) + Personal Taxes (PT)

Real GDP versus Nominal GDP

Economists use the rules just described to compute GDP, which values the economy’s total output of
goods and services. But is nominal GDP a good measure of economic well-being? Consider an economy
that produces only apples and oranges. In this economy GDP is the sum of the value of all the apples
produced and the value of all the oranges produced. That is,

GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges).

Notice that nominal GDP can increase either because prices rise or because quantities rise.

It is easy to see that GDP computed this way is not a good measure of economic well-being. That is, this
measure does not accurately reflect how well the economy satisfies the demands of households, firms,
and the government. If all prices doubled without any change in quantities, GDP would double. Yet it
would be misleading to say that the economy’s ability to satisfy demands has doubled, because the
quantity of every good produced remains the same. The value of goods and services measured at
current prices is called nominal GDP.

A better measure of economic well-being would tally the economy’s output of goods and services and
would not be influenced by changes in prices. For this purpose, economists use real GDP, which is the
value of goods and services measured using a constant set of prices. That is, real GDP shows what would
have happened to expenditure on output if quantities had changed but prices had not. The nominal GDP
can be converted to real GDP by using GDP deflator. It is a type price index that deflates nominal GDP to
its real value.

The GDP deflator may be defined as the ratio of nominal GDP (GDP measured in current prices) and real
GDP (GDP measured in base year prices). Since the GDP deflator is based on all goods and services
produced of the economy, it is a widely used price index. It measures the change in price that has
occurred between the current year and the base year.
To compute today’s real GDP; today’s output [nominal GDP] is multiplied by the ratio of prices of that
year and in the base year. Suppose we use the price level in 2002 as the base year price to measure real
GDP in 2003 and 2004.

Real GDP for 2002 would be

Real GDP = (2002 Price of Apples/ 2002 Price of Apples × 2002 Quantity of Apples)

+ (2002 Price of Oranges/ 2002 Price of Oranges× 2002 Quantity of Oranges)

Similarly, real GDP in 2003 would be

Real GDP = (2003 Price of Apples/2002 Price of Apples × 2003 Quantity of Apples)

+ (2003 Price of Oranges/2002 Price of Oranges × 2003 Quantity of Oranges)

And real GDP in 2004 would be

Real GDP = (2004 Price of Apples/2002 Price of Apples × 2004 Quantity of Apples)

+ (2004 Price of Oranges/2002 Price of Oranges × 2004 Quantity of Oranges).

Notice that 2002 prices are used to compute real GDP for all three years. Because the prices are held
constant, real GDP varies from year to year only if the quantities produced vary. Because a society’s
ability to provide economic satisfaction for its members ultimately depends on the quantities of goods
and services produced, real GDP provides a better measure of economic well-being than nominal GDP.

2.3. Difficulties in Measuring National Income

The calculation of national income is not an easy task. The difficulties faced are as follows.

1. Definition of a nation: while calculating national income, nation does not mean only the political
or geographical boundaries of a country for calculating the value of final goods and services produced in
the country. It includes income earned by the nationals abroad.

2. Stages of economic activities: it is also difficult to determine the stages of economic activity at
which the national income is determined i.e. whether the income should be calculated at the stage of
production or distribution or consumption. It has, therefore, been agreed that the stage of economic
activity may be decided by the objective for which the national income is being calculated. If the
objective is to measure economic progress, then the production stage can be considered. To measure
the welfare of the people, then the consumption stage should be taken into consideration.

3. Transfer payments: this also poses a great difficulty in the way of calculating the national
income. It has generally been agreed that the best way is to consider only the disposal income of the
individuals of groups.
4. Underground economy: no imputation is made for the value of goods and services sold in the
illegal market. The underground economy is the part of the economy that people hide from the
government either because they wish to evade taxation or because the activity is illegal. The parallel
exchange rate market is one example.

5. Inadequate data: in all most all the countries, difficulty has been faced in the calculation of
national income because of the non-availability of adequate data. Sometimes, the data are not reliable.
This is a general difficulty and may not be solved.

6. Non-monetized sector: this difficulty is special to developing countries where a substantial

portion of the total produce is not brought to the market for sale. It is either retained for self-
consumption or exchanged for other goods and services.

7. Valuation of depreciation: the value of depreciation is deducted from the gross national product
to get net national product. But the valuation of such depreciation is full of difficulties. For example,
changes in the price of capital goods from year to year, the age composition of capital stock,
depreciation in cost due to the use of the capital stock, etc.

8. Price level changes: since the national income is in terms of money whose value itself keeps on
changing, it is difficult to make a stable calculation which is assessed in terms of prices of the base year.
But then, the problems of constructing price index numbers will arise.

Importance of National Income Statistics

National income statistics are of great importance. With the help of these statistics one may know the
state of the economy’s performance. Some of the importances of national income statistics are given
below.

1. Indices of national welfare: national income statistics are useful indices of the economic welfare
of the people. With their help one can very easily draw a comparison between the economic conditions
of the people living in different countries and of those living within the country at different periods of
time. These statistics are very useful for knowing the changes in the standard of living of the people all
over the world.

2. Aid to economic policy and planning: national income statistics are pointers to the changes in
the economic activities taking place in the economy under the impact of various policies of the
government. Whether a particular policy has yielded the desired results or not may be known by the
national income statistics. And on the basis of the studies and researches conducted with the help of
these statistics, the policy makers may bring about suitable changes in their policies. They also provide
important tools for economic planning.

3. Index of economic structure: national income statistics are very useful indices of the economic
structure of a country. They provide useful knowledge about the performance of various sectors of the
economy. Thus, one can have a clear idea of the sectors which are lagging behind in economic
development and the sectors which are advancing in economic growth.

4. Useful pace for the formulation of budgetary policies: national income statistics provide a very
useful and important base for the formulation of government budgets. It is on the basis of these figures
that the finance minister is able to have a comparative idea of the importance of different taxation
measures, public borrowing or deficit financing and other fiscal measures. They also help the finance
minister in preparing the budget, particularly in formulating the proposal for a federal government. They
are useful guides for determining the amount of granting, aid and subsidies to be provided to various
units.

5. Significance for defence and development: national income statistics enable the government to
make proper allocation of the national product between defence [non-productive activity] and
development programs [productive activities] of the economy.

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