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.

1
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

2
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.

3
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

4
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.

5
 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.

6
 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.

7
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) Imports 18926.6
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.

8
 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

9
 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)

10
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.

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 = . 100
𝑅𝑒𝑎𝑙 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. We also include the income earned by the
national 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.

11
 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 illegal drug trade is another 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 to be deducted from the gross
national product to get net national product. But the valuation of such depreciation is
full of difficulties. For example, the change in the price of capital goods from year to
year, the age composition of the 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. These statistics are also very useful indices of
the direction for the future policy formulation. The importance of national income statistics
has grown over the years and now in almost every country, they are providing very handy to
the policy makers. The reasons for the growing importance of national income statistics are
as follows.

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
12
 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.

13