Chapter Two

National Income Accounting

Overview of Major Macroeconomic Models

The measurement of an economy or GDP is derived from the circular

flow of expenditure and income.
From the point of view of the number of sectors involved in the
analysis or in the model, there are three major macroeconomic
models;
1 Two sector model
2 Three sector model (Closed economy model)
3 Four sector model (Open economy model)

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1 Two sector model

The two sectors are household sector and the firm sector.
This model is represented by the relation (use) of income by
households either to consume or save income.
This relation is given by the following equation;

Income (Y ) = Consumption (C ) + Saving (S)

Since saving is used for investment or saving is by itself a form of

investment, S = I, the above equation can be rewritten as;

Income (Y ) = Consumption (C ) + Investment (I)

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This model can be demonstrated by using circular flow of income and
expenditure.

Figure 1: Circular flow model with two sector

The model includes two economic agents - households (owners of

resources) and firms (owners of goods and services).
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The two markets - product market (supplied by firms) and resource

market (supplied by households).
Two flows - real flow (resources and goods and services) and financial
flow (payments).
The above model represents a closed and traditional economy
because it involves only two agents in economic system, it excludes
the government and foreign sector.

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2 The three sector model (closed economy model)

This model incorporates government sector.
This model is represented by the following equation;

Income (Y ) = Consumption (C ) + Saving (S)

+ Government expenditure (G)

Income (Y ) = Consumption (C ) + Investment (I)

+ Government expenditure (G)

In addition to the two sector models above, households receive income

from government as transfer payments and pay tax to the government.
Business firms sell their goods and services to the government and pay
tax to the government.
Government sector use the tax income to finance its expenditure.

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Figure 2: Circular flow model with three sector

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3 The four sector model (open economy model)

This model includes trade (import and export ) with other countries.
This model represented by the equation;

Income (Y ) = Consumption (C ) + Investment (I)

+ Government expenditure (G) + [Export (X ) − Import (M)]

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Figure 3: Circular flow model with four sector

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National Income Accounting

National income accounting is the overall recording of economic

activities of a given country in each year.
It is the process of finding out the net output of a country through
additions of value added and payments received after deductions of
depreciation and payments to foreign economy.
It includes GDP, GNP, and GDP per capita of a country.
Gross domestic product (GDP) is the market value of all final goods
and services produced within a country’s domestic territory regardless
of the producer’s nationality in a given period of time usually a year.
GDP adds together many different kinds of products into a single
measure of the value of economic activity.
GDP measures the total income or expenditure of a nation.

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Nominal GDP and Real GDP

Nominal GDP is the value of all final goods based on the existing
prices during the time period of production.
X
Nominal GDP = Pi Qi

Where, Pi is the current general price level and Qi is the the quantity
of final goods and services.
Nominal GDP changes in three ways;
When output changes and price remains unchanged; price changes and
output remains unchanged; When both price and output changes
The problem, then, is how to adjust GDP so that it reflects only
changes in output and not changes in prices.

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Real GDP, on the other hand, is the value of all final goods produced
during a given time period based on the prices of selected base year.
It is also known as GDP at constant price.
It is GDP adjusted for inflation.
X
Real GDP = P0 Qi

Where, P0 is the base year general price level and Qi is the the
quantity of final goods and services.
The adjustment factor is known as GDP deflator.

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The GDP deflator and consumer price index are indexes measure of
change in the general price level.
GDP deflator is the ratio of nominal GDP to real GDP.
Nominal GDP
GDP deflator =
RealGDP
P
Pi Qi
GDP deflator = P
P0 Qi
And the consmer price index (CPI) is the ratio of current cost to the
base year cost.
CPI basket at current year prices
Consumer price index (CPI) =
CPI basket at base year prices
P
Pt Q0
Consumer price index (CPI) = P
P0 Q 0
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The change in either GDP deflator or CPI is said to be

inflation/deflation.
Pt − Pt−1
Inflation =
Pt−1
Where, P could be either CPI or GDP deflator
The difference between the GDP deflator and CPI are;
GDP deflator measures the prices of all goods and services (including
expenditure of both firms and households) whereas CPI measures the
prices of all goods and services purchased by consumers.
GDP deflator includes only outputs produced domestically whereas the
CPI includes price of imported consumer goods.

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Gross Domestic Product (GDP) and Gross National Product

(GNP)
GDP is territorial whereas GNP is something related to citizenship
(i.e. GNP is national).
The difference between GNP and GDP equals to the net income
earned by foreigners (NFP).

GNP = Gross Domestic Product (GDP) + Net Factor Payments (NFP)

Where, Net Factor Payments (NFP) is the difference between income

earned from the rest of the World and paid to the rest of the World.

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Other measures of national income accounts

Net national product (NNP) is the total income of a nation’s
residents (GNP) minus losses from depreciation.
Depreciation is the wear and tear on the economy’s stock of capital.

NDP = Gross Domestic Product (GDP) − Depreciation (D)

NNP = Gross National Product (GNP) − Depreciation (D)

The difference between GDP and GNP is equal to or the same as the
difference between NDP and NNP.

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National income (NI) is the total income earned by a nation’s

residents in the production of goods and services.

National Income (NI) = Net National Product (NNP)

− Indirect Taxes (IT )

Personal income (PI) is the income that households and

non-corporate businesses receive.

Personal income (PI) = National Income (NI)

− [(Social security payments + corporate income taxes
+ retained earnings + other related payment)]
+ [(transfer payments received + subsidies + net interest income
+ related earnings)]

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Personal income (PI) = Wages + Interest + Rent + Dividends

+ Any transfer payments

Disposable personal income (Yd) is the income that left for a person
after payment of and taxes and transfers or that have left after
satisfying all their obligations to the government.

Disposable income (Yd) = Personal income − Personal taxes

Per capita income (PCI) is the average income of the people of a

country in a particular year.
GDP
Per capita income (PCI) =
Population
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Personal saving is the amount of disposable income that is left over

and above consumption expenditure.
In other words, personal saving is the difference between disposable
income (Yd) and consumption expenditure (C) and it is given as
follows:

Saving (S) = Disposable income (Yd) − Consumption (C )

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Precautions to be made in measuring GDP and/or GNP

Money must be used as common unit of measurements.
Market values of goods and services should be applied.
Only final goods and services should be considered.
Non-productive transactions should not be included in GDP.
For instance, sales of second-hand goods and financial transaction.
Products in informal sectors should be included in GDP.

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Approaches to National Income Accounting

1 Value added/Production approach

The total output of a country, gross domestic product (GDP) is
obtained by adding the new values of goods and services created at
different stages of process or in different sectors.
The value added of any producer is the value of its output minus the
value of the inputs it purchases from other producers.
Only the value added at each stage of process in different sectors is
recorded.
For example, consider a farmers selling a wheat at 400 ETB to the first
firm and the this firm sells flour of wheat at 700 ETB to the second
firm, and the second firm sells bread to 1,200 ETB to the final
consumer.Then, the value added is;

400 + 300 + 500 = 1, 200

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2 Expenditure approach
The total output of a country, gross domestic product (GDP) is
measured as the sum of expenditures made in all sectors of the country.
Gross domestic product is the sum of consumption spending by
households, investment spending of the firm, government purchases
and net exports that is purchases of domestically produced goods by
foreigners (exports) minus the domestic purchases of foreign goods
(imports).

Gross domestic product (GDP) = Consumption (C ) + Investment (I)

+ Government expenditure (G) + Export (X ) − Import (M)

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3 Income approach
Gross domestic product (GDP) measured by adding up all of the
income wages and salaries, rent, interest, and profit earned by all
economic agents in the economy.

Gross domestic product (GDP) = Wages (W )+Interest (I)+Rent (R)

+ Profit/Dividends (π) + Undistributed corporate profits
+ Indirect business taxes (IBT ) − Depreciation (D)

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Drawbacks of GDP/GNP measurement

Doesn’t show the income distribution among citizens.
Accounts only for marketed transactions.
Ignores underground (informal) economy .
Doesn’t account the effect of economic growth on environment.
Doesn’t show the level of social welfare.
Difficult for international comparison.
Excludes items produced and sold illegally such as illegal drugs and
home consumption.

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