Chapter 2

Chapter Two:
National Income Accounting
June 22, 2022

National income accounting: is a systematic recording of the economic
performance of a country within a given period of time (usually one fiscal
year).
I It is the measurement of aggregate economic activity of the nation.
I It is the flow of goods and services produced in the economy in a
given period of time and expressed in monetary terms,.
I It gives a money measure of the net aggregate of goods and services
produced as a result of the economic activities of the nation of a
country in a given period of time, usually one fiscal year.
Chapter Two: National Income Accounting June 22, 2022 2 / 43

What are the Importance of the NIA?
The national income accounts are important for the following reasons:
1 NIA helps a country to measure the level of total output in the
economy in a given period of time.
2 NIA helps us to observe the long-run trend in an economy (growth
and decline or economic fluctuations).
3 It provides information to formulate economic policies that can help
improve the economic performance of the country.
4 NIA is used to measure and assess the performance of the economy
and the contributions made by the different sectors of the economy to
the entire economy.

5. NIA give a clear picture of the state of affairs in the economy(role and
area of intervention). They consolidate large masses of unorganized data,
give continuous information about the economy and what can be utilized
to improve the results.
6. NIA can suggest measures for economic welfare, reducing income in-
equalities, cutting down wastages of resources and minimizing costs in the
economy.
7. It help us to compare standards of living of different countries.

2.1 The Concepts and Measurements of National Income
Of the various ways to measure an economy‘s total output, the most com-
mon measures are: the gross domestic product (GDP) and gross national
product (GNP).
Gross Domestic product (GDP) is the total market value of currently
produced final goods and services that are produced with in a country’s
border during a given period of time (usually one fiscal year). Several
features of this definition need to be noted:
I Market value: the possibility of using money values of things
The GDP consists of a combination of variety of goods and services: com-
puter, potato and potato chips, tanks and textbooks, and so on. How can
we combine all of these into a single number? To an economist, there is a
natural way to do so:
I First, convert every good and service into money terms, and then add
all the money up.
I The market price of each good or service is used as an indicator of its
value to society.
I This decision raises the question of which prices to use in valuing
different outputs.
1 we can value each good and service at the price at which it was
actually sold. If we take this approach, the resulting measure is called
nominal GDP or GDP in current.
This seems like a perfectly sensible choice, but it has one serious
drawback as a measure of output: Nominal GDP rises when prices
rise, even if there is no increase in actual production.
2 Using an alternative measures that correct for inflation by valuing
goods and services produced in different years at the same set of
prices. We call it real GDP or GDP in constant dollars.

I In a given period of time: GDP for a particular year includes only
goods and services produced within that year. Sales of items
produced in previous years are explicitly excluded.
I Final goods and services: only final goods and services (are those
that are purchased by their ultimate users (consumers)) count in the
GDP.
I GDP excludes sales of intermediate good and service.
Intermediate goods are those goods purchased for resale or for use in
producing another good. if they were included, we would wind up
counting the same outputs two times - double counting.
I Domestic economy: The adjective domestic in the definition of
GDP denotes production within the geographic boundaries of a given
country. For example, some Ethiopians work abroad, and some of
them have offices or factories in foreign countries. Although all of
these foreign employees of Ethiopian firms produce valuable outputs,
none of it is counted in the GDP of Ethiopia.

I Underground economy and non-market transaction: For the
most part, only goods and services that pass through organized
markets is counted in the GDP.
2. Gross National Product (GNP)
It is defined as the value of all final goods and services produced by domes-
tically owned factors during a specific period, usually one year, irrespective
of their place of residence.
I It measures output produced by the labor and property of citizens,
regardless of where the labor and property are located. On contrary,
earnings of foreigners which arise out of domestic economic activities
are thus excluded.
I For example: For Ethiopians working abroad their income is included
in the GNP of Ethiopia and income earned by foreigners in Ethiopian
economy is included in the GNP of their respective countries.

Approaches of Measuring National Income (GDP)
There are three alternative approaches (methods) for measuring total out-
put, namely:
1 Expenditure Approach
2 Value Added or Output Approach
3 Income Approach
I the fundamental principle underlying national income accounting is
that, except for problems such as incomplete or misreported data, all
three approaches give identical.
1. The Expenditure Approach
All final goods produced in an economy are purchased either by the three
domestic sectors: households, government and business enterprises; or
by foreign nations.
I GDP is the sum of the aggregate expenditure on all-final goods and
services produced in a given year.
I Thus, to determine GDP through this approach, one must add up all
types of spending on finished goods and services by these sectors.
Hence, measuring total output by the expenditure method involves breaking
down total spending on all goods and services produced into four categories:
1 Expenditures by consumers on goods and services (abbreviated

simply to the letter, C);
2 Expenditures by business firms on capital goods (Gross/ total
investment spending, I);
3 Expenditure by government on goods and services, G); and
4 Net exports (the total value of exports minus the total value of
imports, X-M).
Because all spending done in the country falls into one or other of these
four categories, we can say that total expenditure is the sum of C + I + G
+ (X-M)i.eY = C + I + G + NX .
I This equation is called the national income accounts identity.
A. Consumption (C)
Consumption spending is the total of all outlays made by households on
final goods and services. In all countries it is by far the largest component
of total spending.
It is divided into three subcategories: nondurable goods, durable goods, and
personal services
I Nondurable goods are goods that last only a short time, such as
food and clothing.
I Durable goods are goods that last a long time, such as cars and TVs.
I Services include the work done for consumers by individuals and
firms, such as legal advice, haircut, doctor visit, and dental care.

B. Investment (I)
Investment is the production of goods that are not for immediate consump-
tion(i.e goods bought for future use). The total investment in an economy
is called gross Investment. Total or gross investment expenditure may be
divided into three main categories:
I Expenditure on capital goods (Business fixed investment):
purchases of new plant and equipment either to replace existing
capacity that is wearing out or to increase capacity. This is often
called fixed capital formation.
I Residential investment: is the purchase of new housing by
households and landlords for residential purpose.
I Expenditure on inventories: Many businesses find it convenient or
necessary to hold certain supplies of goods on hand voluntarily or
involuntarily. In either case, firms are considered to be investing when
they accumulate inventories.

C. Government Expenditure on Goods and Services (G)
Government Expenditure on Goods and Services (G) are the purchase of
goods and services by:
I federal,
I state and
I local governments.
Government spends on: education, health care services, national defense,
roads, water and sewage systems, postal services.
I However, government support for the elderly, the sick and the
unemployed are not included in GDP since such transfer payments
reallocate existing income and are not made in exchange for goods
and services.
I The same holds true for interest payment on the government debt.

D. Net Exports (X-M)
The External Sector Exports (X) represents an addition to domestic expendi-
ture and must be added to it in order to arrive at an indication of aggregate
demand or aggregate expenditure.
Imports (M) are a subtraction from domestic expenditure.
I Summing these four expenditure components, C + I + G + (X − M),
gives a single figure, the total amount of spending done in the
economy during the accounting period.
GDP = Y = C + I + G + (X − M)
see Numerical Examples on your material

2. Income Approach
The income approach measures the GNP in terms of incomes earned.
I Income approach involves calculation of GDP by summing up all
incomes that derived from the production process.
I In other words, it includes all payments made in respect of the four
factors of production, namely labor, capital, land and
entrepreneurship over a given period of time.
I This implies that the total of all wages and salaries, interest, rent and
profits is conceptually equal to the GDP.
I Using this approach the national income accounts divide incomes into
five categories: compensation of employees, rental income,
proprietors‘ income, net interest, and corporate profits.

a. Compensation of employee It is the payments that made by employers
for labor services.
I These payments are include Wages, salaries, and supplementary labor
income which referring to employee benefits such as pensions, workers‘
compensation benefits, and employer contributions to unemployment
insurance funds or other worker social security schemes.
b. Rental income is the income that received for owning property by
property owners.
I It includes rent payments received by landlords, royalty payments from
patents and copy rights as well as imputed rent that homeowners
—pay to themselves.
c. Similarly, the household receive interest income for exchange in capital.
I The net interest is the interest that the domestic businesses pay
minus the interest they receive.
d. Profit is a residual left after paying for rent, interest on debt, and
employees‘ compensations and other costs.
There are two kinds of profits in national income accounts:
I earning of incorporated enterprises (proprietors‘ income) and
I profit of corporation (corporate profit).
Proprietors‘ income consists of earning of partnership and single owned
business firms or earning of incorporated businesses in general.
Corporate profit is the income of corporations after payments of wage to
their workers and creditors.
I It includes corporate profit taxes, dividends, and undistributed
corporate profits; the latter is what corporations retained in to
business and is called ‘net corporate saving‘ or Retained Earning.

The sum of these five income components gives as the net domestic income
at factor cost.
I But if this figure for factor costs or income is compared with the total
arrived by the expenditure method, it falls considerably short of the
amount expected.
Thus, two adjustments must be made to get GDP at market prices:
1 Indirect taxes minus subsidies are added to get from factor cost to
market prices.
2 Depreciation (or capital consumption allowance) is added to get
from net domestic product to gross domestic product.
GDP at market price=Compensation of employees + Rental income of per-
sons + Net interest+ Proprietor‘s income+ Corporate profits + Deprecation
+ Indirect business taxes (IBT)- subsidy
see Numerical Examples on your material

3. Output or the Value Added Approach
The "value added method" simply sums the net value (value added) of the
output produced by all firms in the economy.
I Value added is the increase in the market value of the product that
takes place at each stage of the production process.
I There are many interactions among firms in a modern economy.
Many produced goods are sold not to final users as consumer goods,
but to other firms.
I In the total product approach the values of each economic sector can
be added at each stages of production.
Stage of production Sales value Value added
Firm A: Wheat 350 350
Firm B: Flour mill 380 30
Firm C: Bakery 420 40
Firm D: Bread whole seller 470 50
Firm E: Bread Retail Seller 550 80
Total value added (Total income) 550
Other Social Accounts
S.no: Expenditure
1 Gross National Product
2 ( - ) Depreciation
3 = Net National product
4 ( - ) Indirect Business taxes (IBT)
5 = National Income (NI)
6 (-) Undistributed corporate profits(RE)
7 (-) Corporate income taxes
8 (+) Gov. transfer payments to persons
9 (-)Social insurance contribution
10 (+) Personal interest income
11 (-) net interest
12 =Personal income
13 personal taxes
14 = Disposal Personal Income (DPI)
Real vs Nominal GDP
I Nominal GDP represents the market value of all final goods and
services measured in the price of that period (current prices).
I Since GDP equals the sum of Pi Qi , the change in either the quantity
of output or the level of prices will affect the size of GDP.
I But the value of different years’ GDPs can be usefully compared only
if the value of money (price) itself doesn’t change as Inflation (or
deflation) complicates the calculation of GDP.

I Rather than price, it is the quantity of goods & services produced
&distributed to households which affects their standard of living, not
the price.
I If, for instance, all prices doubled without any change in quantities,
GDP would double.
I This would be misleading to say that the economy’s ability to satisfy
demands of the people has doubled, because the quantity of every
good produced remains the same.

I Thus, to compare GDPs of different periods nominal GDP must be
adjusted for price level changes. In other words, real GDP should be
used.
I 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.
I Real GDP is a measure value of output that has been adjusted for
price level changes.
I Simply, Real GDP is the value of final output produced in a given
period, measured using prices of a base year (constant prices).

Real GDP may be calculated using:
1 Base year fixed prices
I The countries could have their own base year prices.
I In Ethiopia, MOFED has changed the base year for estimation of real
GDP to the year 2010/2011 (2003 Ethiopian Financial year).
2 Chain-weighted measures of GDP
I The base year changes continuously over time.
Numerical example:
Let us take one example a hypothetical country produces only three products
that are teff, soft drink, machinery. The amount of production and the
price of two years are presented in the following table.
Production 2010/11 2011/12
Price Quantity Price Quantity
Teff 1000 100 1200 100
Softdrink 7 75 8 75
Machinery 2000 25 2500 25
Nominal GDP for 2010/11 year
I Nominal GDP (in 2010/11) = (price of teff (in 2010/11)* quantity of
teff (in 2010/11)) + (price soft drink (in 2010/11) * quantity of soft
drink(in 2010/11)) + (price of machinery(in 2010/11) * quantity of
machinery(in 2010/11))
I Nominal GDP (in 2010/11) = (1000)* (100) + (7) *(75) +
(2000)* (25) =150,525
Similarly, Nominal GDP for 2011/12 year
I Nominal GDP (in 2011/12) = (price of teff (in 2011/12)* quantity
teff (in 2011/12)) + (price soft drink (in 2011/12) * quantity of soft
drink(in2011/12)) + (price of machinery(2011/12) * quantity of
I Nominal GDP (in 2011/12) = (1200)* (100) + (8)* (75) +
(2500)* (25) =183,100

If we make comparisons of the GDP of 2010/11 with 2011/12, the GDP
grew at 21.64 percent.
Nominal GDP(2011/12)-Nominal GDP(2010/11)

GDP growth rate = ∗100
Nominal GDP(2010/11)
(1)
183,100−150,525
Growth rate of GDP= 150,525 ∗ 100 = 21.64
I But if we observe the level of output of three items, are equals as
before.
I It clearly indicates that using nominal GDP for comparative analysis is
misleading.

I Applying a certain constant price in different time horizon solves the
problems.
I Using the price of 2010/11as base year computing the Real GDP of
two years, the Real GDP of 2010/11 and of 2011/12 would be
identical.
Real GDP for 2010/11 year
I Real GDP (in 2010/11) = (price of teff (in 2010/11)* quantity teff
(in 2010/11)) + (price soft drink (in 2010/11) * quantity of soft
I Real GDP (in 2010/11) = (1000) (100) + (7) (75) + (2000)
(25) = 150,525
I At base year Nominal and Real GDP are Equal.

Similarly, Real GDP for 2011/12 year
I Real GDP (in 2011/12) = (price of teff (in 2010/11)* quantity teff
(in 2011/12)) + (price soft drink (in 2010/11) * quantity of soft
I Real GDP (2010/11) = (1000) (100) + (7) (75) + (2000) (25)
= 150,525
I Now, if we make comparisons of the GDP of 2010/11 with 2011/12,
the GDP grew at 0 percent, which is technically true.
I Thus, real GDP is comparatively appropriate measure the rate of
economic growth relative to nominal GDP.

The GDP Deflator and the Consumer Price Index
GDP deflator
I From nominal GDP and real GDP we can compute a third statistic:
the GDP deflator.
I The GDP deflator, also called the implicit price deflator for GDP, is
defined as the ratio of nominal GDP to real GDP.
Nominal GDP
GDP deflator = (2)
Real GDP
I GDP Deflator measures the current price of output relative to its price
in the base year.

Numerical Example
I To make the idea more clear let consider the previous example of a
hypothetical country producing only teff, soft drink, and machinery.
Years Nominal GDP Real GDP
2010/11 150,525 150,525
2011/12 183,100 150,525
GDP deflator(2010/11) = (3)
Real GDP(2010/11)
150, 525
GDP deflator(2010/11) = =1 (4)
150, 525
I This result implies that at the base year, both nominal and Real GDP
are equal and the GDP Deflator always equal to 1 (or 100 in terms of
percentage).

I Similarly, for the year 2011/12 the GDP Deflator computed as:
GDP deflator(2011/12) = (5)
Real GDP(2011/12)
183, 100
GDP deflator(2011/12) = = 1.2164 (6)
150, 525
I This result implies that the price in 2011/12 is 21.64 percent
relatively higher than that of 2010/11.
I The GDP deflator result is used to measure inflation rate.
GDP deflator(2011/12) − GDP deflator(2010/11)
Inflation rate = ∗100
GDP deflator (2010/11)
(7)
1.2164 − 1
Inflation rate = ∗ 100 = 21.64% (8)
1

The GDP Deflator has three purpose:
1 It serve as implicit measure of inflation
GDPdeflatort − GDPdeflatort −1
Inflation rate = ∗ 100 (9)
GDPdeflatort −1
2 The GDP deflator allows us to separate nominal GDP into two parts:
one part measures quantities (real GDP) and the other measures
prices (the GDP deflator). Nominal GDP = Real GDP × GDP
Deflator
3 Help us to deflate nominal GDP to yield real GDP (how the deflator
earns its name: it is used to deflate (that is, take inflation out of)
nominal GDP to yield real GDP.
Nominal GDP
Real GDP = (10)
GDP deflator

Consumer Price Index (CPI)
I Measures the combined price of a particular collection of goods and
services purchased by the consumer in a specific period relative to
the combined price of an identical group of goods and services
in a given reference period.
I It begins by collecting the prices of thousands of goods and services
and contains basically all the goods and services consumed in a
country like food, gas, haircuts, transportation, house rent and so on.
I Just as GDP turns the quantities of many goods and services into a
single number measuring the value of production,
I the CPI turns the prices of many goods and services into a single
index measuring the overall level of prices of goods consumed.

I CPI measures the price of a representative basket called CPI-basket
of goods that purchased by consumers.
I It is used to compare what a fixed basket of goods costs this month
with what it cost in some reference base period.
Cost of market basket of goods at current prices
CPI = ∗ 100
Cost of the same basket of goods at base year prices
(11)
I Note that CPI = 100 for the selected base year
I How should economists aggregate the many prices in the
economy into a single index that reliably measures the price
level?
I They could simply compute an average of all prices. Yet this
approach would treat all goods and services equally. But all goods
and services are not equally bought by typical consumer.

I Because people buy teff than salt, the price of teff should have a
greater weight in the CPI than the price of salt.
I The CSA weights different items by their respective weights by
computing the price of a basket of goods and services purchased by a
typical consumer.
In Ethiopia,
I Central Statistical Authority (CSA) has a job of computing the CPI.
I The CSA calculate and report once a month.
I the CSA determines the market basket that used for CPI calculation
from periodic Consumer Expenditure Surveys,
I Reference period: 2010/11 (2003 E.C.)

The CPI calculation has three steps:
1 Finding the cost of CPI-basket at the base period prices.
2 Finding the cost of CPI-basket at current period prices.
3 Calculating the CPI for the base period and the current period.
Let us use the previous example to discuss how to compute the CPI.
Item Quantity Base-year price(2010/11) Subsequent year price(2
Teff 100 1000 1200
Soft-drink 75 7 8
Machinery 25 2000 2500

The cost of CPI-basket at base period prices: 2010/11
Item Quantity Base-year price(2010/11) Cost of CPI market bas
Teff 100 1000 100,000
Soft-drink 75 7 525
Machinery 25 2000 50,000
Cost of CPI-basket at base year prices( in 2010/11) =150,525
The cost of CPI-basket at a current period prices: 2011/12
Item Quantity Current price(2011/12) Cost of CPI market baske
Teff 100 1200 120,000
Soft-drink 75 8 600
Machinery 25 2500 62,500
Cost of CPI-basket at current year prices( in 2011/12)=183,100

The CPI for the base period and current period.
Cost of a basket of goods at current price
CPI = ∗ 100% (12)
Cost of the same basket at base year
For 2010/11, the CPI is: (150, 525/150, 525)(100%) = 1

For 2011/12, the CPI is: (183, 100/150, 525)(100%) = 1.2164
Inflation rate over a period of time can be computed using the CPI as
follows.
CPIt − CPIt −1
Inflation rate = ∗ 100 (13)
CPIt −1
1.2164 − 1
= ∗ 100% = 21.64% (14)
1

The CPI differs from the GDP deflator in three main ways:
1 The first difference is that the GDP deflator measures the prices
of all goods and services produced, whereas the CPI measures
the prices of only the goods and services 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.
2 The second difference is that 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.

3. The CPI measures the cost of a given basket of goods and services, which
is the same from year to year.
I The basket of goods and services included in the GDP deflator,
however, differs from year to year, depending on what is produced in
the economy in each year.
I In other words, the CPI assigns fixed weights to the different goods,
whereas the GDP deflator assigns changing weights.
I Economists call a price index with a fixed basket of goods a Laspeyres
index and a price index with a changing basket a Pasche index.

GDP and Welfare
I GDP is a reasonably accurate and extremely useful measure of
national economic performance.
I It is not, and was never intended to be, an index of social welfare.
There are important items affecting our wellbeing that are not included in
GDP.
I Pure financial transactions are excluded: Government transfers
payments (social security or cash welfare benefits), private transfer
payments (student allowances or alimony payments), and the sale of
stocks and bonds are excluded because they represent transfer of
existing assets.

I Household services (house cleaning, childcare, meal preparation,
home repair maintenance) are excluded.
I Illegal and underground economic activities are not included in
GDP, because these activities are not reported.
I Leisure time is not included in GDP.
I Volunteer work.
I The quality, composition and distribution of output
I Cost of environmental damage: The costs of environmental
damage are not subtracted from the market value of final products
when GDP is calculated.
I GDP accounting ignores the depletion of natural resources.

End of Chapter 2

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Chapter 2

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Chapter Two:

National Income Accounting

June 22, 2022

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1 Expenditures by consumers on goods and services (abbreviated

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Nominal GDP(2011/12)-Nominal GDP(2010/11)

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For 2010/11, the CPI is: (150, 525/150, 525)(100%) = 1

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