CHAPTER TWO

NATIONAL INCOME ACCOUNTING AND BALANCE OF PAYMENT

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 THE ECONOMY’S INCOME AND EXPENDITURE

 National income -is the sum of all individual incomes

 i) wages, salaries, commissions and labor incomes before
payment of taxes and social security contributions.
 (ii) Interest income from bonds, mortgages, loans, etc.
 After deducting interest paid on government debts,
 (iii) rental income from real property and royalties, and
 (iv) profit of corporation, partnership or proprietorship, before
deduction of taxes based on income.

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 MAIN FEATURES OF NATIONAL INCOME CONCEPTS

 1. flow and not a stock. is the flow of goods and services

produced during a particular period by an economy.
 2.is the money measure of the aggregates of all goods and
services available to the nation in a particular period.
 3.always expressed with reference to a particular period of
time (usually a year).
 4. visualized as a law of national output, national income and
national expenditure.
 For an economy as a whole, income must equal expenditure because:
 Every transaction has a buyer and a seller.
 Every dollar of spending by some buyer is a dollar of income for some
seller.

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 IMPORTANCE OF NATIONAL INCOME STATISTICS

 Indices of economic warfare.

 useful for knowing the changes in the standard of living of the people all over the world. i.e
judging whether the economy is doing well or poorly,
 Aid to economic policy and planning. the policy makers can bring about suitable changes in
their policies, they also provide important tools for economic planning.
 Index of economic structure national income statistics are a very useful index of the
economic structure of a country. They provide useful knowledge about the performance of
various sectors of the economy.
 Useful pace for the formulation of budgetary policies.
 to make proper allocation of the national product between defense and development programs
of the economy.
 to know the relative usefulness of various sectors of the economy and formulate policies
accordingly.
 Knowledge of Structural Changes;
 Signification for Economic Analysis, etc.
 Comparison with other Countries;

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 DIFFICULTIES OF CALCULATION OF
NATIONAL INCOME
 Definition of 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.
 Stage of economic activity: - difficult to determine the stage of economic activity at which the national
income is to be calculated i.e If the objective is to measure the economic progress then the production stage
is to measure the welfare of the people then the consumption stage should be taken in to consideration.
 Transfer payments. It has generally been agreed that the best way is to consider only the disposable
income of the individuals of groups.
 Illegal income, the exclusion of illegal income certainly reduces the size of the national income. (Criminal
activities, tax evasion, and others)
 In adequate data. because of the non availability of adequate data. Some time the data is also not
reliable.
 Non-monetized sector. a substantial portion of the total produce is not bought to the market for sale it is
either retained for self – consumption or exchanged for other goods and services.
 Depreciation valuation. The value of depreciation is to be deducted from the GNP to get the NNP. 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 change in the price of capital goods from year to year, the age composition of the
capital stock, depreciation in cost due to non use of the capital stock, etc….
 Price level changes. it is difficult to make a stable calculation of national income. Which is
assessed interims of prices of the base year.

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  Domestic Territory of a Country: It includes land mass of a
country, territorial waters, ships and aircrafts owned and operated
by residents across countries, fishing vessels, oil rigs and floating
platforms and embassies abroad.
SOME BASIC  Normal Residents: A person or institution who ordinarily resides
CONCEPTS: in a country and whose center of economic interest lies in that
country.
 include the following:
 All producing enterprises operating in a country;
 Nationals of a country and the foreign nationals who stay for one
year or more in the country;
 Ethiopia nationals who have gone abroad but come back within a
year’s time;
 Ethiopia employees working in the foreign embassies and
international institutions located in Ethiopia; and
 Ethiopia students and patients who have gone abroad and stay there
even for more than one year.
 Normal Residents = Nationals living in Ethiopia + Non- nationals living in
Ethiopia.

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 THE PERSONS WHO WILL NOT BE INCLUDED IN THE CATEGORY OF NORMAL RESIDENTS OF A
COUNTRY:

 Foreign nationals visiting the country for study tours, conferences, medical
treatments,
 etc., and staying for a period less than one year (these persons, if they stay on
for more than a year, will be considered as normal residents);
 Crew members of foreign vessels, businessmen and seasonal workers in the
country if their stay is of less than a year
 International organizations (such as IMF, WTO, WHO, ILO, etc.) are not the
normal residents of a country where they are located.
 Foreign national employees of international organizations, if their stay is of less
than a year.
 However, Ethiopia nationals employed in the offices of these organizations
situated in Ethiopia will be considered as normal residents of Ethiopia; and
 • Officials, diplomats and members of the armed forces of a foreign country.
 Non- resident of a Country: if a Ethiopia national goes abroad and stays there for
a period less stays there for more than one year .

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 CONTD

• Flow: It is quantity that can be measured over specific period of the time.
• Stock: It is quantity measureable at particular Point of the time.
• Accounting Year: The financial year which the flow of income in an economy is recorded.
• Capital formation: The surplus of the production over consumption in an accounting year
which is further used for production.
• Final Goods: Goods which directly satisfies human wants.
• Intermediate Goods: Goods which are used in the production process to produce other goods.
• Per Capita Income: This is the average income of the citizens of a country obtained after
dividing national income by living population.
• Subsidies: economic assistance given to the producing unit by the state for compensating the
cost of product so that it is available to consumers at affordable prices.
• Factors of production/Primary Inputs/Economic Resources: Resources/goods which is used
in the production process. For example land, labor, machines, power etc.

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 A FOUR SECTOR MODEL: CIRCULAR FLOW OF INCOME

Gov’t borrow
Financial Market
Firm borrow
International
market Saving (S)
Product Market
(Goods & Services)
Rest of Firm
World X Payments G&S Household Government

M Tr

Received (wage, rent, interest, profit)

Factor Market (Labor, capital, land,

Entrepreneur)

Government Purchases

Goods & Services Supplies

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 CGE: CIRCULAR FLOW OF INCOME

Factor Domestic Private Savings

Factor Markets Wages
Costs & Gov. Savings
Rents
Taxes
Demand for
Intermediate Households Government Saving/INV
Producers Inputs
Transfers
Private Government Investment
Product Consumption Expenditure Demand
Sales Markets
Revenues Demand for Final Goods
Imports
Foreign Savings
Exports Rest of the
World
 HOUSEHOLDS:

• They are assumed to own all factors of production (land, labor,

capital, and entrepreneurship).
• They supply all these resources to firms.
• As a result they receive income i.e. rent for land, wages for labor,
interest for capital, and profits for entrepreneurship.
• This income will be allocated for consumption, saving and tax
payments to government

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 FIRM

• Supply goods and services to households and receives

payments for goods and services.
• And also supplies goods & services to government
and receives payment for it.
• Supply capital goods to other firms in the goods
market this will flow back to firms as investment
expenditure and firms finance their investment by
borrowing from households through financial market.

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 GOVERNMENT:

• Collects taxes from households and pays transfer

payments like pension payments, social security
funds and unemployment benefits.
• Net tax = Tax –Transfer payments
• This net tax allocated to government purchases for
buying goods and services from firms and pay for
these goods and services.
• When there is a deficit the government finances the
deficits by borrowing from households through
financial markets
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 • Firms supply goods and services to
foreigners and receive export earnings.
THE REST OF THE • The rest of the world supply goods and
WORLD services to firma and firms pay for goods
and services; this will be import expenditure

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 SOME CONCEPTS OF NATIONAL INCOME AND RELATED
AGGREGATES:

Gross Domestic Product at Market Price (GDP );M P

• Gross Nation Product at Market Price (GNP MP);
• Net Domestic Product at Market Price (NDPM P );
• Net Nation Product at Market Price (NNP M P );
• Gross Domestic Product at Factor Cost (GDP FC);
• Gross Nation Product at Factor Cost (GNP FC);
• Net Domestic Product at Factor Cost (NDP FC);
• Net Nation Product at Factor Cost (NNP FC);
• Private Income;
• Personal Income;
• Personal Disposable Income

MP MP
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 GROSS DOMESTICPRODUCT(GDP)
 “GDP is the Market Value . . .”
 Output is valued at market prices.
 “. . . Of All. . .”
 Includes all items produced in the economy and legally sold in markets
 “. . . Final . . .”
 It records only the value of final goods, not intermediate goods (the value is counted only once).
 “. . . Goods and Services . . .”
 It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor
visits).
“. . . Produced . . .”
 It includes goods and services currently produced, not transactions involving goods produced in the past.
 “ . . . Within a Country . . .”
 It measures the value of production within the geographic confines of a country.
 “. . . In a Given Period of Time.”
 It measures the value of production that takes place within a specific interval of time, usually a year or a
quarter (three months).

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 • It is the measure of economy activity.
GDP • For example, Ford Motor Company in Detroit is
factored into the United States’ GDP; Toyota
Motor Corp. in Dallas is also considered a part of
our GDP. However, a Ford factory in Japan
would not be considered in our GDP because the
goods are not produced on U.S. soil.

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  includes all items produced in the economy and sold legally
GDP in markets.
 What Is Not Counted in GDP?
 GDP excludes most items that are produced and consumed
at home and that never enter the marketplace.
 It excludes items produced and sold illicitly, such as illegal
drugs.

GDP (Y) is the sum of the following:

 Consumption (C)
 Investment (I)
 Government Purchases (G)
 Net Exports (NX) [EXPORTS – IMPORTS]

Y = C + I + G + NX

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 • Consumption (C):
• The spending by households on goods and services, with
the exception of purchases of new housing.
• Investment (I):
• The spending on capital equipment, inventories, and
structures, including new housing.
• Government Purchases (G):

• The spending on goods and services by local, state, and federal

CONTD governments.
• Does not include transfer payments because they are not made in
exchange for currently produced goods or services.
• Net Exports (NX):

• Exports minus imports.

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 GDP M P

 The most widely used measures of national

 the market value of final goods and services produced by a nation during a specific period, usually 1 year.
 Features of GDP
 It includes only final goods and services produced in the domestic territory of a country;
regardless of ownership of the resource during a year.
 It includes consumption of fixed capital (depreciation);
 • It is estimated at the prevailing prices.
 It takes in to account the geographical boundary.
GDP-is a poor measure of social welfare:
 Leisure
 Home and volunteer labor
(non market production)
 Depletion of nonrenewable resources
 Unregulated pollution
 Distribution of income
 Differences in preferences

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 MEASUREMENT PROBLEMS AND LIMITATIONS OF GDP AS A MEASURE
OF WELFARE

  Social Welfare & GDP - GDP and GNP are nothing more than measures of total output (or income). More
information is necessary before conclusions can be drawn concerning social welfare. There are problems with
both measures, among these are:
 a. Nonmarket transactions such as household-provided services or barter are not included in GDP.
 b. Leisure is an economic good but time away from work is not counted, however, movie tickets, skis, and
other commodities used in leisure time are.
 c. Product quality - no pretense is made in GDP to account for product or service quality.
 d. Composition & Distribution of Output - no attempt is made in GDP data to account for the composition
or distribution of income or output. We must look at sectors to determine composition and other information
for distribution.
 e. Per capita income - is GDP divided by population, very rough guide to individual income, but still mostly
fails to account for distribution.
 f. Environmental problems - damage done to the environment in production or consumption is not counted
in GDP data unless market transactions occur to clean-up the damage.
 g. Underground economy - estimates place the amount of underground economic activities may be as much
a one-third of total U.S. output. Criminal activities, tax evasion, and other such activities are the underground

economy .
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 • Three possible approaches to measure (GNP) or
(GDP).
• These are
The output/Product approach
The income/ Factor income in production process
approach
The expenditure approach
 
APPROACHES

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 1.VALUE ADDED METHOD OR PRODUCT METHOD

• The economy consists of either public or private enterprises.

• The enterprises contribute to the production with the help of given factors of production.
• In the economy the produced goods are useful for producers and individuals or we can say that
they are either consumer goods or the producer goods.
• In the same way there are various people who are not directly producing. But without providing
their services the economy cannot run.
• For example the services of doctor, teachers, Police, bank services etc. are necessary for
economic development.
• Those people who are providing these services are paid in terms of the wages and salaries.
• states that if we add all the money value of the final goods and services in domestic territory of
the in an accounting year time gives us Gross Domestic Product at market prices

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 STEPS FOR THE ESTIMATION OF NATIONAL INCOME BY VALUE ADDED OR
PRODUCT METHOD

 1) Estimating the value of Gross Domestic Product of the different sectors of an economy.
 The producing sectors of an economy divided into three parts
 A. Primary Sector (AGRI)
 B. Secondary sector (INDUSTRY)
 C. Tertiary sector (DISTRIBUTION SECTORS)
 2) Determining the cost of Materials and services provided by the sectors
 3) Determining the net value added of the domestic product and
 4) Adding the factor income from abroad
GDP= AGRI +INDUSTRY+DISTRIBUTION SECTORS.

Example:
Wheat (Br. 80) Flour (Br.100) Bread (Br. 120)
GDP = 80 + 20 (value added) + 20 = 120 or the value of final goods at market
price which is Br. 120.

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 PRECAUTIONS WHILE ESTIMATING NATIONAL INCOME THROUGH VALUE
ADDED METHOD

• A. Net Increase in stocks should be included.

• B. Own account production of fixed assets by all the producer enterprises
should be included.
• C. Non- marketed goods and services for self-consumption should not be
included.
• D. Imputed rent of owner occupied houses should be properly counted and
included.
• E. Sales and purchase of second hand goods should not be included.
• F. The brokerage or commission of second hand should be included because
it is productive services rendered by them.
• G. Trading of stocks and bonds should not count in the estimation of
national income
• because it does not represent the production of new assets.

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 FINAL GOODS VS INTERMEDIATE GOODS

• it is important to include only final goods and services in on

order to avoid double counting.
• final goods and services which are being purchased for final
use and not for resale or further processing.
• intermediate goods - purchase or goods and services for
resale or for further processing or manufacturing.
• Therefore, to avoid double counting, the sale of final goods
should be included and the sale of intermediate good should be
excluded from GNP because the value of final goods already
includes the value of intermediate goods involved in their
production.

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 EXAMPLE 2.1

Sector Value of out put (in million birr )

1.Agriculture and allied activities 8000
 forestry 1000
 Agriculture 1500
 Fishing 5500
2.Industry 12,200
 mining and quarrying 1200
 large and medium scale 5000
manufacturing
 electricity and water 4000
 construction 2000
3.distribution 20,000
 banking and insurance 10,000
 Defense 2250
 Education 3250

 Health 2000

 Other services 2000

4.capital consumption allowance 6200

5. Net income from a broad 4000

GDP will be given as 8000+ 12200+20000= 40200

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 THE SUM OF THE VALUE ADDED METHODS
 Value added is the market value of firm’s output less the value of the inputs purchased from others.
 Example 2.2
 A farmer produces oil seeds and sells it to edible oil factory for birr 10,000.
 The oil factory uses the oil seeds to produce edible oil, which it sells to retailers for birr 15,000 Retailers buy the oil
and sell it for birr 24,000
 using the value added method compute the value of the final product.
 Why do national in come accountants in clued only final goods in measuring total output?
 Solution
 let’s summarizes the stages of production as fallows

Stages of production Value of output Cost of intermediate Value added

goods
Farmer 10000 0 10000
Oil factory 15000 10000 5000
Retailers 24000 15000 9000
Total 24000

2
 As you observe in the above table, the sum of value added is equal to the final value (24000). 8
 CONTD

• Net value added at FC = Gross value of output - IG - Dep - NIT

• By adding up net value added at FC of all the producing units of a sector
we get net value added at FC of that particular sector.
• The sum total of net value added at FC of all the three sectors in the
domestic territory of a country gives us Net Domestic Product at Factor
Cost.
• Thirdly: Net National Product at factor cost is obtained by adding net
factor income from ROW to net domestic product at factor cost.
• If net factor income from ROW is negative, NDP at FC will be greater
than net national product at factor cost (National Income), and if it is
positive national income will be greater than NDP at FC.

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 2.INCOME
METHOD

• estimated by adding incomes earned by all factors of production for their factor
services during a year.
• The factor services include land, labor, capital and enterprises.
• These factor services received the income against their services.
• The factors income distributed as follow:

Factors of Production Factors Income

1.Land 1. Rent
2.Labour 2.Wages or Salaries
3.Capital 3.Interest
4.Enterprises
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 STEPS OF INCOME METHOD

 I. Identifying the producer enterprises which employ factors of production

 All the producer enterprises are divided into three main sectors:
 primary, secondary and tertiary sector.
 II. Classification of Factor Incomes
 Factor incomes are generally classified into three groups
 A. Compensation to the employees
 B. Operating surplus (Rent +Interest+ Profit) and
 C. Mixed Income of the self employed
 III. Estimating Factor Payments—
 Payment made by different individual enterprises to the factors of production for rendering
factor services .
 Adding the factor payments by all enterprises in an individual sector, we get factor payment of
that sector.
 By adding the incomes paid out to all the sectors of the domestic territory of the country, we get
domestic factor income or the national income.

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 PRECAUTIONS WHILE ESTIMATING NATIONAL INCOME THROUGH
INCOME METHOD

•  A. All government expenditure on transfer payments, such as

Unemployment benefits, old age Pensions, scholarships etc.
should not be included. because they are received without
rendering any productive services.
• B. Value of imputed rent owner-occupied houses should be
included.
• C. Incomes earned through illegal activities like smuggling, tax
evasion etc. should not be included.
• D. Windfall gains like lottery income should not be included.
• E. Money received for sale and purchase of second hand goods
and bonds and share should not be included in factor income.
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 CONTD

 payments received by all citizens of the counter that have contributed in the current year production are
added to get GNP includes
A. Compensation to employees © -wages and salaries and their supplements like employer’s contributions in social
security, pension, health and welfare funds, which are paid by business firms and government to suppliers of labor

B.Rents ®- Payment to households that supply property resources .

C. Interest(I)-payments by private firms to household which supply capital. However, interest payment made by government
is excluded.

D. profit(II) includes proprietors’ income (profit of unincorporated business) and corporate profit. Proprietors’ income refers
to the net income of sole proprietors, partnerships and cooperatives. While corporate profits include corporate income taxes
(part flow to government), dividends (part divided to stock holders) that are payment flow to households and undistributed

corporate profits that are retained as corporate earning.

D. Depreciation (capital consumption allowance) (D) be used to replace the machinery and equipment
used up in the production process.
E .Indirect business tax (IBT) These taxes are treated as cost of production. includes sales taxes,
excise taxes and custom duties etc.
F. subsides.

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 CONTED
• There fore, GDP and GNP using income approaches are given as follows:

GDP = C+ R+ I+ II+ D+ IBT – subsidy

GNP=GDP + net income from a broad

Gross national product at Market price (GNPm) includes indirect business taxes (IBT) and
subsides, while gross national product at factor cost (GNPf) excludes indirect business taxes
and subsides. This relation ship is given as follows:

GNPm = GNpf +IBT – subsides

GNPf = GNPm – IBT+ subsides

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 GROSS NATIONAL PRODUCT (GNP MP)

• The market value of final goods and services produced by labor and property supplied
by the residents of a nation during a specific period, usually 1 year.
• is the market value of all final goods and services produced by resources owned by
citizens of a country during a year.
• It measure the money value of all finished goods and services produced in an economy in a
given year.
• In general, GNP measures the money value of output produced by every citizen of that
country regardless of whether he/she is currently living in the country.

GNP = GDP + NFIA

G N P M P = Gross National Product at market price

G D P M P = Gross Domestic Product at market price
NFIA= Net factor income from abroad
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 NET FACTOR INCOME FROM ABROAD
(NFIA):
• The difference between the income received from abroad for rendering
factor services by the normal residents of the country to the rest of the
world and income paid for the factor services rendered by non-residents
in the domestic territory of a country.
• Gross Domestic Product at Factor Cost(GDPFC)

G D P = Domestic Factor Income + Consumption of Fixed Capital

G D P FC = GDPM P – IT + S

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 CONTD

Gross National Product at Factor Cost (GNPFC ): It is the difference between the GNPM P and
net indirect taxes. It is the sum of net domestic factor income, consumption of fixed capital and
net factor income from abroad. Symbolically,

GNP FC = GNP M P – IT + S

GNP FC = Domestic Factor Income + NFIA + Consumption of fixed capital.

IT = Indirect Taxes; and

S = Subsidies.

Net Indirect Tax: The difference between IT and S is known as net indirect tax
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 EXAMPLE 2.5

Types of income Amount (in billion birr)

Compensation of employees 10,8000
Proprietor’s income 400
Rental income 600
Corporate profit 4000
Net interest 170
Deprecation 1600
Indirect business taxes 200
Income earned by foreigners in the country 500
Income earned by citizens abroad 800
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 CNTD

• Compute GDP using income approach

• Compute GNP using income approach
• Solution
• GDP using income approach is determined as follows:
• GDP = C + R +I + II + D + IBT
• GDP = 108100+ 600+ 170 + 400 + 4000 + 1600 + 200 = 17770 billion birr
• GNP = GDP + Net income from a broad
• GNP = 17770 + 800 – 500 = 18070 billion birr

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 3.EXPENDITURE METHOD

 (GDP) is the sum total of all final expenditure on various goods and services within domestic territory of the country,
during a year.
 The main components of the final expenditure are as follows;
 I. Private Final Consumption Expenditure(C)
 II. Investment Expenditure (I)
 III. Government purchase of goods and services(G)
 IV. Net Exports (X-M) Where, X for exports and M for Imports
 Mathematically the expenditure method to calculate the national income written as
 Y= C+I+G+(X-M) + Net Factor Income from Abroad
 Where,
 Y is the National Income
 C is the Private Consumption Expenditure
 I is the Investment Expenditure
 G is the Government Purchases of the goods and services
 X-M is the net Exports

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 PRECAUTIONS OF EXPENDITURE METHOD

•  A. Expenditure on second hand goods should not included

• B. Expenditure on bonds and shares should not be included
• C. All government expenditure on transfer payments, such as
Unemployment benefits, old age Pensions, scholarships etc. should not be
included.
• D. Expenditure on all intermediate goods and services should not be
included.

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 EXPENDITURES

 can be categorized into 4 groups depending on who buys the goods or services.
 personal consumption Expenditure (C) includes expenditures by households on durable
goods like cars, refrigerators, video records, automobiles etc, non-durable goods like
bread, beer, cigarettes, pencil, tea et c and for services like barber, restaurant, lawyer,
mechanics etc.
 Gross private Investment (Ig) includes added investment and depreciation.
 If we take only the added investment, which has occurred in the current year, then we get
net private investment

  

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 GROSS PRIVATE DOMESTIC INVESTMENT (IG)

• spending by business firms. includes all purchases of machinery, equipment and tools by business enterprise, all
construction like building of a new factory and change in inventories.
• Investment also includes residential construction. This is because like factories, residential house are income-earning
assets. That means they can be rented to yield money income as a return.
• Since GNP measures the value of output produced in a given year, in order to get accurate measures of GNP, we must in
clued the market value of inventories, which are produced in the given year but not sold in the same year.
• If we exclude inventories from GNP, then it would understate the given year’s total production
• If business firms have more goods on their shelves, then the economy has produced more than it has consumed during
the given year. This increase in inventories should be added to GNP. On the other hand, if there is a reduction in
inventory, then the economy sells output, which exceeds current production. This reduction in inventory must be
subtracted from GNP, because GNP measures the value of current year’s output. However, investment does not include
the transfer of money or assets. It does not also include the buying of stocks and bonds, because such purchases transfer
the ownership of existing assets.
• There fore, gross private domestic investment include the production of all investment goods, which include the additions
to the stock of capital and replacing the machinery, equipment and building used up in the current year production.

Net private investment = Gross private investment – depreciation

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 GOVERNMENT PURCHASE OF GOODS AND SERVICES (G)

• It includes all government spending at different

layers of the government like at federal, state and
local, on final goods and services.
• However, it excludes all government transfer
payments because such payments don’t reflect
current production

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 NUTSHELL

• When gross investment exceeds depreciation or when net investment is

positive, the economy is expanding (growing) i.e. its stock of capital is
growing.
• When gross investment and depreciation are equal or when net investment
is zero, the economy is static economy i.e. it is producing enough capital
to replace what is consumed in producing the given year’s output
• Whenever gross investment is less than depreciation or whenever net
investment is negative i.e. when the economy uses up more capital than it
produces, the economy will be disinvesting (declining). In other words,
when depreciation exceeds gross investment, the nation’s stock of capital
is less at the end of the year than at the beginning of the year.

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 EXAMPLE 2.3

• Suppose in 1993 a certain economy produced about 10 billion birr worth of capital
goods. However, in the process of producing, the economy used up 4 billion birr
worth of machinery and equipment.
• Determine the net private in vestment
• What is the difference between gross private domestic investment and net private
domestic investment?
•  Solution
• Since 10 billion Birr worth of capital goods private investment and 4 billion Birr
worth of machinery and equipment are the value of the capital used up in the
production processes in 1993 (depreciation ) , the difference between the two (10
billion -4billion =6 billion birr) is the private investment of the given economy in
1993.
• Net private investment excludes deprecation

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 NET EXPORT (NE)

Net export (NE) = Export –Import

Spending by foreigners in a certain country may contribute just as spending by the citizens.
Hence, we have to add the value of net export in determining GNP. On the other hand, the
value of import (produced a broad and do not reflect productive activity of a country) should
be subtracted. Net export is the difference between the amounts by which foreigner spending
on a certain country and the amount by which citizens spending on foreign country. In other
words, net export is the difference between export and import
 When export exceeds import, net export is positive.
 When export is equal to import, net export is zero.
 When export is less than import, net export is negative
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 CONTD

• For example, foreign countries buy 10 billion dollar worth of capital from country A (i.e. exports) and country A buys
8 billion dollar worth of capital from foreign countries (i.e. import )in a given year, net export of country A would be
2 billion dollar (10 billion dollar- 8billion dollar).
• In general, the value of gross domestic product of any economy will be given as

• A country may own resources in foreign country, which leads to a flow of in come from a
broad in to the country, denoted by I1, resources owned by foreigners in a country may lead to
outflow of income to a broad from the country, denoted by I 0 the difference between in come
inflow (I1) and income outflow (I0) is know as net factor income from a broad.

GDP = C + Ig + G + NE

Net I = I1 – I0

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 THE RELATIONSHIP BETWEEN GNP AND GDP

GNP = GDP + net income from a broad

GNP = GDP + (I1 – I0 )

You can observe the following relationship:

 when I1 > I0 , GNP exceeds GDP

 when I1 = I0 , GNP equals GDP
 when I1 < I0 , GNP is less than GDP

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Example 2.4

This example will help you to develop the skill of computing GNP and/or GDP using the
following hypothetical data of a certain country answer the questions below.

Value in billion birr

1. Capital consumption allowance (depreciation) 1220
2. Personal consumption expenditure 6320
3. Government spending on goods and services 5000
4. Transfer payment 650
5. Income earned by foreigners in the country 500
6. Net investment 5780
7. Income earned by citizens a broad 800
8. Export 500
9. Import 750

Using the appropriate method, calculate GDP and GNP

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Solution

GNP= C + Ig + G + NE

= C + net investment + depreciation + G + NE

Where GNP = Gross national product

C= personal consumption expenditure

Ig = Gross private investment

G= Government purchases of goods and services

NE = net export

GNP = 6320 + 5780+ 120+5000+500-750

GNP = 18070 billion birr

GDP = GNP - (I1 – I0 )

= GNP + ( I0–I1)

= 18070+500 -800

GDP = 17770 billion birr

How was this 17770 billion birr of expenditure of the hypothetical country allocated or
distributed as income? It would be simple if we could say that total expenditures on the
economy’s yearly output flow to households as wages, rent , interest, and profit incomes but
the picture isNURA A
complicated 11/13/22
by two non-income charge against the value of total output.5 These
are consumption of fixed capital (depreciation) and indirect business taxes 1
OTHER SOCIAL
• These are:
ACCOUNTS
• Net Domestic Product (NDP):
• Net national Product (NNP)
• National Income (NI)
• Personal income (PI)
• Personal disposable income (PDI)

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 NET DOMESTIC PRODUCT (NDP):

• Economists derive NDP by taking GDP and subtracting the

depreciation of capital equipment.
• In other words, NDP is GDP adjusted for depreciation.
• Net Domestic Product at factor cost = w + i + r +π
• Net Domestic Product at market prices = NDP @ factor cost +
Indirect tax (IT) –Subsidies
• Gross Domestic Product (GDP) at market prices = Net Domestic Product
at market prices + Capital Consumption Allowances + Statistical
Discrepancy
•  GDP = NDP + Depreciation or NDP = GDP - Depreciation

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 NET NATIONAL PRODUCT (NNP)

• is a more accurate measure of economy’s annual output than gross

national product and it is given as:

Net National product =Gross National product – Capital consumption allowance

(NNP) (GNP) (D)

N N P MP = G N P MP – D

Where,

N N P M P = Net National Product at Market Prices

G N P MP = Gross National Product at market price
D = Depreciation

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 CONTD

Sectors Value of out put (in million birr)

1. Agriculture and allied activities 8000
 Forestry 1000
 Agriculture 15000
 Fishing 5500

1. industry 12,200
 mining and quarrying 1,200
 large and medium scale manufacturing 5,000
 Electricity and water  
 Construction 4,000
2,000

1. Distribution 20,000
 Banking and insurance 10,000
 Defense 2,250
 Education 3,250
 Health 2,000
 Other services 2,000

4. Capital consumption allowance 6200

5. Net income from a broad 4000
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 CONTD

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 NATIONAL INCOME (NI)

• is the income earned by economic resource (input) suppliers for their contributions of
factors of production
• It measure the income received by resource supplier for their contributions to current
production. However, from the components of NNP, indirect business tax, which is
collected by the government, does not reflect the productive contributions of economic
resources because government contributes nothing directly to the production in return to
the indirect business tax. Hence, to get the national income, we must subtract indirect
business tax from net national product.

National income = Net National product – indirect business tax + subsidies

(NI) (NNP) (IBT) (S)

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 PERSONAL INCOME (PI)

• Part of national income like social security contribution (payroll taxes), and corporate income taxes are not
actually received by individuals.
• Therefore, they should be subtracted from the national income. On the other hand, transfer payment, which
include welfare payments, veterans’ payments, unemployment compensation, are not currently earned.
Therefore, in order to get personal income (PI) which is a measure of income received by individuals, we must
subtract from national income those types of income which are earned but not received and add those types of
income which are received and but not currently earned.

Personal income (PI) =National income (NI) - social security contribution (SSC) -
corporate profits -Net interest + transfer payment + Dividend + personal interest income

Distinction between Private Income and Personal Income: Private income includes all the
payments which accrue to individuals from whatever sources while personal income includes
only those payments which are actually received by the individuals

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 CONTD

Personal Disposable Income = Personal Income – (Direct Taxes + Fines, Fees, etc. + Social
Security Contributions by Employees)

Net National Disposable Income: It is the sum of national income, net indirect taxes and other
current transfers from the rest of the world. In other words,

Net National Disposable Income = National Income + Net Indirect Taxes + Net Capital
Transfers from the rest of the World

Per Capita Income (PCI): It is the average income of the normal residents of a country.
Symbolically,
𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 (𝑁𝑁𝑃𝑎𝑡 𝐹𝑎𝑐𝑡𝑜𝑟 𝐶𝑜𝑠𝑡)
PCI =
𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛

Real Income: The income measured in physical term or in terms of the quantity of goods and
services. It is calculated at some base year.

Nominal income: The income measured in term of current price.

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 PERSONAL DISPOSABLE INCOME (PDI)
• is the difference between personal income and personal income taxes. It is the amount of
income which households divided it as saving and consumption. Personal taxes include
personal income taxes, personal property taxes and inheritance taxes.
Personal Disposable Income = personal income – personal income taxes
(PDI) (PI) (PIT)

Types of income Amounts (in birr)

Wages and salary 40000
Rents 2000
Interests 1500
Gross profits 10000
Net income from a broad 8000
Capital consumption allowance 6000
Indirect business tax 4000
Subsidy 3000
Personal income tax 2000
Income outflow from the country 1420
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 CONTD

 Based on the information available in the above table compute

 GDP at factor cost
 Net national product (NNP)
 Income inflow from a broad
 National income
 Solution
 1a. GDP = 40000+2000+1500+10000=53500
 1b. NNP = GNP –Capital consumption allowance
 = GDP + net income from a broad –capital consumption allowance
 = 53500 + 8000-6000
 NNP = 55500
 1c. income inflow from a broad = 8000+ 1420 =9420
 1d. NI = NNP – indirect business tax + subsidy

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 GDP VS GNP

• GDP: is used to measure the overall performance

of an economy.
• GNP: is the value of output produced by nations of
a country at a given period of time.
• GNP = GDP + Receipts of Ethiopian citizens
working abroad – Payments to foreigners working
in the country or;
• GNP = GDP + Net Transfer Payments

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Figure 1. GNP by Disposition of Income and Value of Output (in billions)
*GNP…………………………………2369

GNP = C + S + T + Rf = 1510 + 354 + 504 + 1

Less Depreciation……………………243 (+)

NNP…………………………………2126

less Indirect Business taxes…….........189

Business transfers……………………10

Statistical discrepancy………………4 (+)

Plus -net subsidy………………………2 (-)

*NI………………………………………1925 Saving

Less-net business savings…………… .33 (+) (354)

Corporate profit taxes…………………92 (+)

Contribution for social insurance………190 (+) Tax (504)

Plus-government transfers……………242 (-)

Net-government interest…………….23 (-)

Business transfer………………………10

Personal interest……………………….40

*Personal Income (PI)…………………1924

Net-transfers to foreigners…………1 Rf (1)

= 2369
Less personal
Personal taxes…………………300 (+)
interest……………………40

PersonalExpenditure……………1510
Consumer Disposable Income (PDI)……1624
C (1510)

Less personal
NURA A saving………………………74 (+) 11/13/22 6
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Figure 2. GNP by Types of Income (in billon)

GNP………………………………………….2369

Depreciation………………………………..243

NNP…………………………………………...2126

Less indirect business tax…………………….189

Business transfers……………………………..10

Statistical discrepancy…………………………4

Plus-net subsidy………………………………..2

National Income (NI)………………………1925 (2126-189-10-4+2)

Compensation to employees……………………1459

Rental income……………………………………27

Net interest………………………………………130

Proprietors income……………………………….131

Corporate profits…………………………………178
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 CONTD

• Note: Depreciation is saving because it is expressed as money and

transfer payments such as taxes have no real values. Real GDP
measurement is affected by
• Purchasing Power of Money (i.e. affected by inflation)
• Un-fair income distribution
• Suppose that country A has GDP per capita of $500; and that of B has
$1000. Do mean that peoples of B are twice better off country A? No!
The reason is that economic welfare depends on many other factors that
are not captured by Real GDP. Real GDP doesn’t reflect important
indicator of quality of life such as life expectancy, leisure time,
environmental quality, political freedom and social justice etc.

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 MEASURING THE COST OF LIVING

 A. The GDP Deflator

 called the implicit price deflator for GDP,
 is defined as the ratio of nominal GDP to real GDP.
 GDP deflator = Nominal GDP X 100%
 Real GDP
 The GDP Deflator-
 reflects what’s happening to the over all level of prices in the economy.
 the price of bread in that year relative to the price bread in the base year, P.P base.
 measures the price of out put relative to its price in the base year.
 allows us to separate nominal GDP in to two parts, one part measures quantities (real GDP) and the other measures
prices (the GDP deflator) that is
 . Nominal GDP
 measures the current dollar value of the out put of the economy.
 the total number of dollars spent on bread in that year, PXQ.
 Value of output measured at actual prices (current dollar output)
 the money value of all finished goods and services according to price during the year in which the goods and service
are produced.
 the value of current production in terms of current prices.
 influenced by both changes in the price and production (output) Does not correct for inflation.
 Nominal GDP = Current year Quantities x Current year Prices
NURA
 Nominal GDPA= Real GDP X GDP deflator 11/13/22
 REAL
GDP
 The number of loaves of bread produced in that year times the price of bread in some base year, p base
x Q.
• (RGNP)-the money value of all finished goods and services using a certain base year price.
• nominal GNP adjusted to eliminate inflation.
• It is preferable to nominal GNP because it indicates the state of the economy and it is important for
analyzing production condition.
• Value of output based on prices of some base period (“constant” dollar output)
• eliminates effect of inflation

Real GDP = Current year Quantities x Base year Prices

N o m in al G D P2 0X X
R eal G D P20 X X  1 0 0
G D P deflato r2 0X X
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Item 2000 2001

Price Qty Price Qty

A 10 50 15 80

B 50 30 40 30

C 40 100 60 95

D 200 10 250 12

Nominal GDP of 2001 = 15x80+40x30+60x95+250x12= 11,100

Real GDP of 2000 = 10x80+50x30+40x95+200x12= 8500
GDP deflator = No min al GDP2001
Re al GDP2000

11,100 =
 1.306
8500

Rate of Inflation = (GDP deflator – 1) x100= 30.6%

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 B. CONSUMER’S PRICE INDEX (CPI)

• Refers to a measure of the costs of buying a fixed basket of goods and services
representative of the purchase of urban consumers. In other words, the CPI measures the
average level of prices of the goods and services that a typical urban family consumed.
• Example: let see above item A and C represent the consumer basket from the above table.
Further, a typical urban family consumes 5 of A and 15 unit of C so
• The expenditure of household 2001 = 15x5 + 60x15 = 975
• The expenditure of household in 200 = 10x5 + 40x15 = 650
• If item A and C were sold at 2000 price, the household expenditure would amount only
650. But due to an increase in price the household expenditure has increased to 975. Thus,
the increase in living expense which is measured by CPI would be:

CPI =
975650 x100 = 50% (measuring living expense)
650
• When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

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 HOW THE CONSUMER PRICE INDEX IS CALCULATED

1. Fix the basket. Determine what prices are most important to the typical consumer.
• The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical
consumer buys.
• The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and
services.
2.Find the prices. Find the prices of each of the goods and services in the basket for each
point in time.
3. Compute the basket’s cost. Use the data on prices to calculate the cost of the basket of
goods and services at different times.
4.Choose a base year and compute the index.
• Designate one year as the base year, making it the benchmark against which other years are compared.
• Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

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 INFLATION RATE

• 5.Compute the inflation rate. The inflation rate is the percentage change in the price index
from the preceding period.
• refers to a situation in which the economy’s overall price level is rising.
• The inflation rate is the percentage change in the price level from the previous period.

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 WHAT IS THE DIFFERENCE BETWEEN GDP
DEFLATOR AND CPI?

• GDP deflator considers all items produced in a country but

the CPI takes only the consumer basket.
• GDP deflator considers the change in price and quantity
where as in CPI we use consumer price basket that cannot
change from year to year.
• GDP deflator concerns the amount of item and even type of
item depends on what the economy produced in the year
under consideration.
• CPI includes the imported item but in GDP deflator we
consider only item produced in a country.

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 CONTD

 GDP Deflator
 All goods included
 Base-year prices
 Quantities variable
 Imports excluded

 Consumer Price Index

 Includes only consumer goods
 Base year quantities
 Prices variable
 Imports included

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 C. PRODUCER PRICE INDEX

• Likewise the CPI the PPI is a measure of cost of a given basket of goods. However, it differs from the CPI
partly in its coverage which includes for example raw material, and semi-finished goods.
• The PPI is serve as a signal for changes in general price level because its valuation includes raw materials.
• Any change in its raw material especially those of ‘sensitive materials’ will in the long run have their effect on
the price of final goods.
• Policy makers identify these sensitive materials and closely watch this indexes as an indicator of business cycle.
• Generally, PPI measures cost of production.
• Examples of sensitive materials are fuel, fertilizers, cement, oil food, sugar etc
• Suppose look the given below table

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 Item 2000 2001

Q P Q P

Fuel 3 100 6 100

Fertilizer 110 1060 120 1060

Cement 100 50 200 50

Cost of production in 2001 = 6x100+120x1060+200x50= 137,800

Cost of production in 2000 = 3x100+110x1060+100x50 = 121, 900
PPI = 137,800121,900 x100
121,900

= 13.1%

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 PROBLEMS IN MEASURING THE COST OF LIVING

• The CPI is an accurate measure of the selected goods that make up the
typical bundle, but it is not a perfect measure of the cost of living.
• Substitution bias
• Introduction of new goods
• Unmeasured quality changes
• Substitution Bias
• The basket does not change to reflect consumer reaction to changes in
relative prices.
• Consumers substitute toward goods that have become relatively less
expensive.
• The index overstates the increase in cost of living by not considering
consumer substitution.

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 CONTD

• Introduction of New Goods

• The basket does not reflect the change in purchasing power brought on by the introduction of new
products.
• New products result in greater variety, which in turn makes each dollar more valuable.
• Consumers need fewer dollars to maintain any given standard of living.
• Unmeasured Quality Changes

• If the quality of a good rises from one year to the next, the value of a dollar
rises, even if the price of the good stays the same.
• If the quality of a good falls from one year to the next, the value of a dollar
falls, even if the price of the good stays the same.
• The BLS tries to adjust the price for constant quality, but such differences are
hard to measure.

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 GALATOOMAA

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