Chapter 2: National Income Accounting: Methods of Macroeconomics Analysis

2.1. Definition and function of national income accounting

National Income Accounting:

is the measurement of aggregate economic activity, particularly, national income

and its components.

It is a systematic recording of the economic performance of a nation with in a

given period of time.

National income:- is a measure of the money value of all final goods and services
that are produced in a country in one year. National income is always measured
in money value.

Since the unit of measurement of all the final goods and services are not the
same, it is not possible to sum up their values without using a common
denominator. This common medium is money.
 Cont’d….
Functions of National Income Accounting (NIA)

It helps a country to measure the level of total output in the

economy in a given period of time.

It provides the basis for evaluating economic policy. If

national income accounts allow us to measure the severity of a

problem, they can also be used to determine how effective

public policy has been in solving it.

It helps us to observe the long-run trend in an economy

(growth and decline or economic fluctuations).

 Cont’d….

It provides information to formulate economic policies that can help to

improve the economic performance of the economy and the

contributions made by the different sectors of the economy to the entire

economy.

It enables us to identify the basic macroeconomic problems (inflation,

unemployment).

In the national income accounting process, the terms ‘Gross national

product (GNP) and Gross Domestic Product (GDP) are usually used

as an approximate of each other. But there is a distinction between gross

domestic product (GDP) and gross national product (GNP).

2.2. Basic concepts of Gross Domestic Product (GDP) and
Gross national product (GNP)
Gross Domestic Product (GDP): is the value of final goods and
services produced by domestically owned factors of production
within a given period. Gross domestic product (GDP) is the sum of
values of goods and services produced in the country by citizens of
the country and foreigners. Therefore, GDP is something related to
territory of the country (i.e. GDP is territorial). (note that GDP is a
flow not a stock).

Example: If chine’s residents owns a building in Addis Ababa, the

rental income he earns is part of Ethiopian GDP. This is because of
produced by domestic factors of production.
 Cont’d….

Gross national product (GNP): refers to the market values of

all final goods and services produced by all citizens of a
nation/a country all over the world in the country plus outside
the country. GNP is something related to citizenship (i.e.
GNP is national).
Example: If Mr ‘X’ (Ethiopian citizen) living in USA, owns its
own assets. The asset of Mr ‘X’ counted as GDP for USA but
GNP for Ethiopia.
 The difference between GNP and GDP equals to the net factor income

(NFI).

Note:- GNP = GDP + NFI (Net factor income)

NFI = Factor income received – Factor income

from abroad paid abroad

GNP may be greater, equal or less than GDP

If NFI > 0, then GNP>GDP

If NFI = 0, then GNP = GDP

If NFI < 0, then GNP<GDP

When GDP exceeds GNP, residents of a given country are earning less

abroad than foreigners are earning in that country.

 GDP is more commonly taken as the basic measure of a nation’s
output as compared to GNP. This is because:
 GDP is easier to measure, since data on net foreign earnings are
usually poor,
 GDP is better measure of the job-creating potential of the economy
than is GNP, and
 It makes international comparisons easier, as most countries use
GDP.
 NIAs ignore:
1. transactions involving intermediate goods (in order to avoid
double counting).
2. non-productive transactions, i.e.,
i) Purely financial transactions (public & private
transfer payments, and buying & selling of
securities) as recipients make no contribution to
current production in return.
ii) Second-hand sales as such sales either do not
reflect current production or involve double
counting.
2.3. Approaches of measuring national income (GDP/GNP)
In the calculation of GDP or GNP need to consider:
Final Goods and Value Added: GDP is the value of final goods and services
produced to make sure that we do not double-count. For example, we would not
want to include the full price of an automobile in GDP and then also include as
part of GDP the value of the tires that were sold to the automobile producer to put
on the car.

Intermediate goods is not included in GDP.

Current Output: GDP consists of the value of output currently produced. (Note
that GDP is a flow not a stock).

Market Prices: GDP values goods at market prices. The market price of many
goods includes indirect taxes such as the sales tax and excise taxes, and thus the
market price of goods is not the same as the price the seller of the goods receives.
 Cont’d….

Example: To compute the total value of different goods and

services, the national income accounts use market prices
because these prices reflect how much people are willing
to pay for a good or service. Thus, if apples cost $0.50
each and oranges cost $1.00 each, GDP would be;

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

of Oranges × Quantity of Oranges) = (Birr 0.50 × 4) +
(Birr 1.00 × 3) = Birr 5.00.
 Cont’d….

There are three major approaches/methods of measuring

GDP or GNP of a certain country. These are:
I. The total product (value added) approach;
II. The income approach and
III. The expenditure approach
1. The total product (Value added) approach: In this method two

approaches – ‘Final Product Approach’ and ‘Value Added Approach’ – are

adopted.

a. Final Product Approach: According to this approach, in the estimation of

GDP, we include the market value of all final goods and services produced

in a country. Thus, GDP is calculated by multiplying all the final goods

and services produced in a country with their respective market prices.

GDP = P (Q) + P (S)
Where, P = Market price

Q = Quantity of goods

S = Quantity of services

Problem of Double Counting in the Final Product Approach

b. Value added approach
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. Only the value added at each stage of process in
different sectors is recorded.
For instance, take one ‘quintal’ of wheat, costing 200 Birr in the
farm.
A hypothetical data to show how to calculate value added in a five
stages of production.
Stage of process Total value of the Value added
quintal wheat at each (in Birr)
stage (in Birr)
Wheat at farm 200 200
Wheat in the market including transportation 250 50
Wheat flour in the market 310 60
Bread in the market/ Wholesaler 460 150
Sandwich at cafeteria/retailer 530 70
If all the process are undertaken in the same year 530
If the wheat was produced one year earlier it would be recorded in
GDP of that year (previous year), so that year’s income or GDP
includes only 330 Birr.
That is, we exclude the value of wheat at the farm (200 birr) since
it should be recorded in the GDP of previous year.
Such record must be made for all items produced in the different
sectors of the country.
Since this method is very prone to error of double recording.
Because of this defect this method is not frequently used. The
other two approaches i.e. expenditure approach and income
approach are widely used.
2. Income Approach: When we use the income approach to measure
GDP or GNP, we add up all the incomes earned by different
factors of production: land, labor, capital and so on. Thus, the
national income identity is given by the following relation.
GDP = Y = W + R + I + Π + Adjustments (IT +D). where,
GNP = Y = Gross national product
W = Wages of all workers (compensations of employees)
R = Rents paid to property owners
I = Interest on borrowed capitals
Π = Profit of business organizations
IT = Indirect business taxes
D = Depreciation (Capital consumption allowance)
3. Expenditure Approach: gross domestic product (GDP) is
measured as the sum of expenditures made in all sectors of
the country.
The underlying assumption of using expenditure in
measuring income is that the expenditure of one sector or
person is the income of the other (receivers of that money
spent by other sectors). Thus, the national income identity is
given as follows:
GDP = Y= C + I + G + X – M
GDP = Y= C + I + G + NX
Personal consumption expenditure (C) includes expenditures by households on

durable consumer goods (Television, automobiles, video, cars etc) and non-

durable consumer goods (food items and others) and consumer expenditure of

doctors, mechanics etc.

Gross private domestic investment (I) is all investment spending by business firms

(all final purchases of machinery, equipment and tools by business enterprises all

construction materials; and changes in business inventories)

Government spending (G) includes all Spending on goods and services, lasting

public assets like schools and highways and Expenditure on research and

development and other activities that add to the economy's stock of knowledge.

Exports are goods and services sold to foreign countries

Imports are goods and services bought (purchased) from foreign countries.
Table: GDP using expenditure approach
Components Value in Birr
Personal consumption expenditure (C) ------------------------------11,400
Gross private domestic investment (I) --------------------------------- 6,500
Government expenditure (G) -------------------------------------------7,300
Exports (X) -------------------------------------------------------------------900
Imports (M) --------------------------------------------------------------(1,100)
Total Expenditure (equivalent to national income/output, GDP)--25,000
The value of the GDP in the above example is calculated by summing up
the first four items and by deducting the fifth item that is imports (M).
Thus:
GDP = Y = C + I + G + X – M = 11,400 + 6,500 + 7,300 + 900
– 1,100
GDP = 25,000
2. 4. Other Social Accounts (GNP, NNP, NI, PI and DI)

Net national product (NNP): is equal to GNP minus depreciation

allowance (consumption of fixed capital).

Net national product (NNP) =GNP– depreciation

Depreciation: - The consumption of capital goods in the production

process, the wearing out of plant and equipment.

National income (NI): the total income earned by current factors of

production. Adjust NDP by subtracting indirect business taxes and

adding net income earned abroad.

NI = NNP – Indirect Business Taxes (sales tax, excise tax, business

property tax)
Indirect Business Tax (IBT) is a tax levied (imposed) by the government

as value added and excise duty.

Personal income (PI): is income received by households before payment

of personal taxes. To calculate, take NI minus payroll taxes (social

security contributions), minus corporate profits taxes, minus undistributed

corporate profits, and add transfer payments.

Personal Income (PI) = National income - Corporate taxes -

Retained earnings - Social security insurance +Transfer payments +Net

interest

Disposable income (DI): is personal income less personal taxes.

Disposable personal income (DPI) = PI – personal income tax

GDP + NFI

= GNP –D

= NNP – IBT

= NI + Net Transfer
payments Received
– Social security
contributions
– C Taxes
– Undistributed C

= PI – PT
= DI

21
 2.3 Nominal versus Real GDP

 Nominal GDP: the market value of all final goods & services
at current prices.
 But productions of different years’ cannot be compared
using NGDP since the value of money changes.

 Because GDP is a price times quantity figure (PiQi), changes

in either quantities or prices affect the size of NGDP.

 But it is the quantity of goods & services produced &
distributed which affects the standard of living, not the
price.
 To compare GDPs of different periods (or to see changes in
economic performance) NGDP must be adjusted for price
changes.
 In other words, real or constant-Birr GDP should be used.
 RGDP measures each year’s output in terms of the prices
prevailed in a selected base year.
To distinguish the increase in the quantity of goods and services from

increases in their prices, we must construct a measure of GDP that take

into account price level changes. Thus the distinction between

nominal and real GDP is important whenever the level of price

change.

Changes in nominal GDP that results from price changes do not tell us

anything about the performance of the economy in producing goods

and services. That is why we use real rather than nominal GDP as the

basic measure for comparing output in different years.

 Cont’d….

This simply means that to get the most appropriate measure of

national economic performances, nominal GDP (NGDP)
should be adjusted to the real GDP (RGDP).
This can be done by deflating NGDP when price is rising and
by inflating it when price is falling.
The adjustment factor is known as GDP deflator. GDP deflator
is the ratio of nominal GDP to real GDP.
 2.5 The GDP Deflator & the Consumer Price Index
 The GDP deflator, also called the implicit price deflator of GDP, is
defined as follows: Nominal GDP
GDP Deflator   100
Real GDP
 GDP deflator reflects what is happening to the overall level of
prices in the economy.
 NGDP = RGDP x GDP deflator (/100)

Measures the Measures the Measures the

current economy’s
monetary price of output
B output at
B
value of the relative to its
B
constant
economy’s prices price in the base
output year
 2.5 The GDP Deflator & the Consumer Price Index
 Price Index: measures the combined price of a basket of goods &
services in a specific period relative to the combined price of the
same basket in a reference period.
 CPI is the most commonly used measure of the level of prices (or
cost of living).
 Just as GDP turns the quantities of many goods & services into a
single number, the CPI turns the prices of many goods & services
into a Cost
singleofindex.
a Market Basket of Products at Current Prices
CPI   100
Cost of the Same Basket of Products at Base Year Prices

 Note: CPI = 100 for the selected base year.

 (𝑃𝑖𝑡 ∗𝑄𝑖𝑜 )
𝐶𝑃𝐼𝑡 =σ ( )*100
(𝑃𝑖𝑜 ∗𝑄𝑖𝑜 )

CPI: measuring the cost of living

where ’Qi,o’ represents the quantity of the ith good consumed in the
base time period,

’Pi,o’ represents the price of the ith consumption good in the

base time period, and

’Pi,t’ represents the price of consumption good in the current

time period ’t’.
• GDP deflator is based on a calculation involving all the goods produced in the
economy.
 2.5 The GDP Deflator & the Consumer Price Index

 CPI & GDP deflator differ in 3 main ways:

1. GDP deflator measures the prices of a wider set of goods & services than

CPI.

– A change in the prices of goods & services bought by firms or the

government will show up in GDP deflator but not in CPI.

2. CPI measures the cost of a given basket of goods & services, which is the

same from year to year. The basket of goods & services included in GDP

deflator differs from year to year – fixed vs. changing weights assigned to

goods & services.

3. CPI directly includes prices of imports, whereas the GDP deflator includes

only prices of products produced domestically.

 Neither of the two indices is clearly superior to the other in measuring the
cost of living.
 Moreover, the difference between them is usually not large in practice.
 Thus, the CPI is also used to deflate nominal GDP so as to arrive at the real
GDP.
Inflation rate based on GDP_deflator and CPI
50

40

30

20

10

0
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
-10

-20

GDP_def CPI
• Example: Suppose the nominal GNP of a country be 80 billion dollars in 2005 year and
the price index for that year was 110. Calculate the real GNP for the given year.

Solution: Real GNP = Nominal GNP x 100

Price index

= 80x100 = 72.73 billion dollars

110

Example: Suppose that the gross national product of a country was 1500 million dollars in
2005 and 1660 million dollars in 2006. Calculate the annual rate of growth of the economy.

Annual growth rate = Real GNPt year - Real GNP t-1 year x 100

Real GNP t-1 year

Soln : Real GNP 2006 – Real GNP2005 x100

Real GNP 2005

= 1660 – 1500 x 100 = 10.70 %

1500
 Problems in measuring GDP and economic welfare/ Standard
of living

 GDP and/or GNP is useful measure of social and economic

wellbeing and level of economic performances.

 The values of the GDP and/or GNP are the best measure or
representative figure of the economic activities of a country.

 Yet, as a measure of social welfare or economic activity of a

country, these figures are not free from weakness.
The problems with the GDP and/or GNP are the following:

The first issue is wealth distribution; GDP does not describe properly whether
or not all the people are truly benefitting from economic growth.

The real income distribution is not known from the figure of GDP or GNP.

Omission of some transactions: some goods and services are very difficult to
assess in terms of money. Example, Items produced within households such as
cooking, washing, entertaining.

The underground economy: Income earned from informal/illegal activities

such as smuggled goods, production of harmful drugs such as hashish, cannabis
etc… are not included in GDP because of the difficulties of getting access to
such information.

GDP ignores the side effects of economic growth on the environment and
welfare of the societies.
 Macroeconomic Problems and Policies
Instruments

Macroeconomic Problems: Macroeconomic problems will

occur if the macroeconomic goals of the economy are not
achieved. Here are some of the common macroeconomic
problems are:
Business Cycle fluctuation ,
Unemployment and
Inflation
 The Business Cycle
 Business cycle: the term used to describe fluctuations in aggregate
production as measured by the ups & downs in RGDP.
 It is the non-regular pattern of expansion & contraction in
economic activity around the path of trend growth.
 The trend path of GDP is the path GDP would take if factors of
production were fully employed.
 Over time, RGDP changes for 2 reasons:
1. More resources become available: rise in population size, improved
land, rise in stock of knowledge. This allows the production of more
goods & services, resulting in a rising trend level of output.
• Resources are not fully employed all the time. Even without
open/observable unemp’t, there might be disguised unemp’t
(underemp’t) of resources. Similarly, there are times when
resources are employed to work overtime and used for several
shifts. This implies output fluctuations over time.

Trend Level/
Output (Real GDP)

Peak
Potential/
Con essio
(Re

Full-Emp’t
Output
trac n)
c

Actual
ti o n

(Rec sion
y)
over
Output
n
Expa

Trough

Time
 Deviations of output from trend are referred to as the
output gap. The output gap measures the gap between
actual output and the output the economy could produce at
full employment given the existing resources.

Full employment output is also called potential output or

trend output (we use these terms interchangeably).
Output gap = actual output - potential output
 Business cycle movements are not regular in timing or in

size.

 Nor is the trend growth rate constant: it varies with

changes in technical knowledge & the growth of supplies

of resources.

 Output gap: deviations of output from trend (= Potential

Output – Actual Output).

 Output gap grows during recessions, & declines (& even

becomes negative) during expansions.

• When GDP at its highest point above trend, in a given period, it is at its peak.

• When GDP is at its lowest point below trend, in a given period, it is at its trough.

• The length of time between the peak and trough is the business cycle.

1. Peak to trough phase: contraction (recession)

2. Trough to peak phase: expansion (recovery)

 For there to be a recession, GDP needs to be consistently below trend for a

given period of time.

Recession and depression

 A prolonged contraction is called recission (more than 6 months)

 A recission of more than one year is called depression

Period of expansion

• Increase demand for goods

• More production

• Increased employment

• Wages and salaries increase

• More income

• People are optimistic and spend more

• Business starts to make profit

Peak

• The economy stops growing (reached top)

• GDP reaches maximum

• Business can not produce any more or hire more

Contraction

• Known as recission

• Business reduce production

• Business layoff employes

• Unemployment increase’

• Decrease income

• People are pessimistic and reduce their spending

• Banks stop lending

Trough

• All economic activates are the lowest

• High unemployment and low spending

• Lest production

• Very low income

 GDP And Other Variables: Some Stylized Facts

• Investment is more volatile than GDP(households can postpone residential

investment and businesses can postpone investment decisions until

circumstances are favorable).

• Employment/unemployment is less volatile than GDP. (Adjustment in

labour market)

• Private consumption and investment are strongly positively correlated with

GDP.

• Employment is procyclical with GDP.

• GDP is persistent

• Employment is even more persistent than GDP.

 Unemployment and Inflation
Unemployment
Unemployment is the macroeconomic problem that affects people most directly and

severely.

For most people, the loss of a job means a reduced living standard and psychological

distress.

Unemployment: refers to the situation where workers of the working age could not find

job while they are ready to work at prevailing market wage rate in a given periods of time.

The problem of unemployment and its intensity is usually measured in terms of

unemployment rate.

This is because talking about the actual number of unemployed people makes no sense

for countries of different population size.

Measuring Unemployment: unemployment is measured using unemployment rate

Unemployment rate: is defined as the percentage or the
proportion of the labour force that is unemployed or has
no job while they are ready to work at prevailing wage
rate.

Labour force (L) is the sum of both employed (E) and

unemployed people of working age and working or ready
to work (U). This can be given by the following equation:
L = E + U ------------------------------------------------------------------(3.1)
Then, unemployment rate (R) is calculated as follows;

 Number of Unemployed 
Unemployment Rate (UR) =   X (100)
 Labour Force 

U 
(R) =   X (100)                  (3.2)
L
 
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝒑𝒆𝒓𝒔𝒐𝒏
Employment rate (ER) =
𝑳𝒂𝒃𝒐𝒖𝒓 𝒇𝒐𝒓𝒄𝒆

 Labour Force 
Labour Force Participat ion Rate    X (100)
 Adult Population 
 Unemployment and Inflation
• 2.7.1 Unemployment
Total population

Working-age Population Population outside Working-age

Labor Force (Currently Population Not

Active Population) Currently Active

Employed Unemployed
• A person is said to be unemployed if he/ she is in the working-
age, without work, available for work & actively seeking work.

Number of Unemployed
Unemp' t Rate   100
Number of labor force
 Types of Unemployment:

• Types of Unemployment:

1. Frictional Unemp’t: unemp’t resulting from people who have left

jobs that didn’t work out & are searching for new emp’t, or people

who are either entering or re-entering the LF to search for a job.

2. Structural Unemp’t: unemp’t resulting from permanent shifts in the

pattern of demand for goods & services or from changes in

technology such as automation.

3. Cyclical Unemp’t: unemp’t resulting from declines in RGDP during

recessions, or whenever the economy fails to operate at its potential.

 The total amount of unemp’t is the sum of frictional,
structural, & cyclical unemp’ts.
 Frictional & structural unemp’ts result from natural &
unavoidable occurrences in a dynamic economy
 Cyclical unemp’t, however, is the result of imbalances b/n
aggregate purchases & aggregate production at full-emp’t.
 Cyclical unemp’t receives the greatest attention since it is
viewed as controllable.
 Full emp’t does not mean zero unemp’t. It occurs when the
actual rate of unemp’t is no more than the natural rate of
unemp’t.
 The time, effort & transaction costs required to find a new job

guarantee that there will always be some unemployed workers

looking for jobs.

 Natural rate of unemp’t is the percentage of the LF that is

normally expected to be unemployed for reasons other than

cyclical fluctuations in RGDP.

 In other words, natural rate of unemp’t is the sum of frictional &

structural unemp’ts expected over a period (a year).

 An economy with actual unemp’t rate less than the natural rate

is said to be an overheated economy.

 An overheated economy can produce more than the potential

RGDP.

 But, most economists believe that this couldn’t happen for long

periods without consequences that impair its future performance

& ultimately cause actual RGDP to decline to its potential level.

 Cyclical Unemp’t (usually characterized by layoffs - temporary

suspensions of employment without pay) tends to rise during

recessions.

 This negative relationship between changes in RGDP & changes

in unemp’t rate is known as Okun’s law.

Natural rate of unemployment:
Natural rate of unemployment:
Policy implication
Natural rate of unemployment: is the average rate of
unemployment around which an economy fluctuates given by U/L
= n at that point.
It is related to the rate at which workers lose job (job loss rate)
and the rate at which jobless workers find or get job (job
finding rate).
It is a rate where there is no cyclical unemployment or when
all the unemployment is frictional and structural ones.
To determine the natural rate of unemployment, let as start with some notation.

Because every worker is either employed or unemployed, the labor force is the

sum of the employed and the unemployed:

L=E+U

In this notation, the rate of unemployment is U/L= n

This can be more elaborated as follows using the steady state unemployment rate.

Steady state unemployment rate is the point or condition in which the number

of workers leaving or losing job are equal to the number of unemployed getting

or finding job.

The labor market is in steady state, or long-run equilibrium, if the

unemployment rate is constant.

 The natural rate of unemployment is the long-run average or “steady state”
rate of unemployment. It depends on the rates of job separation and job
finding.

fU = sE …………………………………….(3.3)

Where ‘f’ is rate of job finding

‘s’ is rate of job separation or loss

‘U’ unemployed population

‘E’ Employed population

 Remember: L=E+U

Rearranging the equation into E = L – U and substituting in terms of E, we obtain

the following relation:

fU = s(L – U) dividing both sides by L

fU/L = (s/L)(L – U)

fU/L = s( 1 – U/L) dividing both sides by ‘f’ we obtain

fU/L = s – sU/L multiplying both sides by (1/f)

U/L = s/f – (s/f)(U/L) rearranging

U/L + (s/f)(U/L) = s/f

U/L[ 1 + (s/f)] = s/f

U/L[(f + s)/f] = s/f multiply both sides by f/(s + f), we obtain:
 U/L = (s/f) [f/(s + f)] letting U/L = n

n = [s/(s + f)]
Where U/L = n is the natural rate of unemployment

The policy implication of this is that any policy aimed at

reducing the natural rate of unemployment should either

reduce the rate of job separation (losing job), or increase the

rate of job finding (f). Moreover, any policy that affects the

rate of job separation (s) or job finding (f) also affects the

natural rate of unemployment ‘n’.

 Generally, there is always some amount of unemployment and

economists very frequently use the term full employment.

Full employment occurs when the unemployment rate is equal

to the natural rate of unemployment.

Note: the concept of full employment does not mean that all

workers are employed.

Examples:
• If 90% of labour forces of a given country with 10 million labour

force populations are employed on average, find the unemployment

rate of the country.

• If 3% of workers are on average leaving or losing their job and on

average 40% of unemployed workers and workers newly joining

labour market are finding or getting job, then what is the natural rate

of unemployment?

• In question number ‘1’ if the size of the adult population of the

country is 12 million, what is the labour force participation rate?

Solutions:
1) L = E + U

L = 90%(L) + U

L – 0.9(L) = U

0.1L = U

U/L = 0.1 = 10%

2) Given: job separation rate (s) = 3% = 0.03

job finding rate (f) = 40% = 0.4

U/L = n = [s/(s + f)] proved above

= [0.03/(0.03 + 0.4)]

= 0.03/0.43

= 0.0698

n = 6.98%
3, labor forece participation rate
= (10 million/ 12 million) X 100
= 83.33%
 Causes of unemployment :

Lack of labour market information

Sectoral shift result in demand for workers also shift and some

workers have to leave some sectors, and look for jobs and join some

other sectors

Structural changes in the economy related to skill, education level,

geographical area, technological change, age, etc

Real wage rigidity: the failure of wages to adjust to a level at which

labor supply equals labor demand.

General downturn/recession in the business activities including

production and demand for the products

fluctuations in demand for labour in some seasons or sectors

Voluntary unemployment: There are some people who are between

jobs because of choices they have made. They may have resigned

from a job in anticipation of a move to another location before they

have another job lined up or be planning to return to school.

Costs of Unemp’t:

 Unemp’t is of great concern because it has costs. The main costs of

unemp’t are:

1. Output is lost (GDP falls) because the economy is not at full employment.

2. Distortional impact – unemp’t usually hits the poor harder than the rich

& this raises the problem of raising income inequality.

3. The unemployed may have more leisure when not working. But this

benefit is more than offset by costs to the society since:

 the value placed on that leisure is small as much of it is unwanted leisure,

and

 government loses income tax revenue.

 Effects/ consequences of unemployment
The effects of unemployment are wide-ranging and include:

High costs to the government: The government takes on higher costs since it has to

provide security to the unemployed, so when fewer people have jobs, the government

has to pay more to support them.

Reduction in spending power for consumers: The spending power of both the

unemployed and those still working goes down, since those without jobs can't pay for

goods while those who are employed face increased taxes and economic uncertainty.

Economic recession: The combination of reduced work forces and reduced spending

can lead to recession. With the increase rates of unemployment other economy factors

are significantly affected, such as: the income per person, health costs, quality of

health-care, standard of leaving and result in recession.

• 2.7.2 Inflation
 Inflation is a rise in the general price level.
 With inflation, the purchasing power of a nation‘s currency
declines over time.
 Deflation is the opposite of inflation (it is a fall in the general price
level).
 Annual inflation rates are measured by percentage change in a
price index from one year to the other.
 Percentage change in CPI is the commonly used measure of
inflation, followed by percentage change in GDP deflator.
CPI t  CPI t 1
Inflation Rate at Period t   100%
CPI t 1
 The greater the weight attached to an item in the CPI, the greater the

impact of a change in its price on inflation rate.

 Pure Inflation: when the prices of all goods rise by the same percentage

over the year.

 If an economy experiences pure inflation, there will be no changes in

relative prices.

 So, pure inflation does not affect incentives & thus decisions of

consumers/producers.

 Hyper Inflation is inflation at very high rates (> 600%) prevailing for at least

a year.

 Disinflation is reduction in the annual rate of inflation (the price level

The CPI may over-estimate inflation

The CPI is the most commonly used price index to measure the

inflation rate. However, the CPI has several limitations/may

overestimate inflation due to:

a. CPI fails to adjust for improvements in quality:

Price indexes have difficulty measuring changes in quality.

Consumers benefit from higher quality products.

When inflation calculations use a fixed basket of goods, however,

the implicit assumption is the quality does not change. A product

could be more expensive because it has improved in quality.

b. Price indexes have difficulty including new
technology.

Consumers benefit from new technology, but the

fixed basket of goods used in the CPI will not
include the newest products and technology.

Thus, the CPI is an inaccurate measure of the

true cost of living of a typical urban consumer.
c. Substitution bias

The CPI measures the price of a fixed basket of goods; it does not reflect the ability

of consumers to substitute toward goods whose relative prices have fallen. Thus,

when relative prices change, the true cost of living rises less rapidly than the CPI.

When prices of different goods are changing by different amounts, a Laspeyres

(fixed basket) index tends to overstate the increase in the cost of living because it

does not take into account the fact that consumers have the opportunity to substitute

less expensive goods for more expensive ones.

By contrast, a Paasche (changing basket) index tends to understate the increase in

the cost of living.

Although it accounts for the substitution of alternative goods, it does not reflect the

reduction in consumers’ welfare that may result from such substitutions.

 Due to the above factors, the best guess is that the CPI overstates
inflation by 0.8 to 1.6 percentages in an annual basis.

As the reason once after estimate the inflation rate using CPI need to
deduct 0.8 to 1.6 to reach at actual inflation rate.
Real Income Vs Consumer Price Index

Real income is a person’s nominal income (or money income)

adjusted for any change in prices. As real income measures the
purchasing power of an individual's wages, analysts often compare it
to the Consumer Price Index (CPI). Real income is computed as
follows:
 Types and Causes of Inflation:

1. Demand pull inflation: it is inflation resulting from an increase in

aggregate demand for goods and services while the economy is
producing at or close to full employment. At full employment
income is rises, this result in AD>AS→shortage→P↑.
Demand pull inflation arises due to:

Growing of aggregate demand at an unsustainable rate leading

to increased pressure on scarce resources and a positive output
gap (i.e Actual output > potential output)

Excess demand for products: at this time producers can raise their
prices and achieve bigger profit margins.

Full employment of resources and aggregate supply is inelastic

A depreciation of the exchange rate: increases the
price of imports and reduces the foreign price of a
country's exports. If consumers buy fewer imports,
while exports grow, AD in will rise and there may be
a multiplier effect on the level of demand and output

Expansionary monetary or fiscal policy which

results in increase in nominal money supply: This
enables people to hold excess cash balances.
 Currency inflation: This type of inflation is
caused by the printing of currency notes.

Seigniorage: the revenue from printing money

results in hyperinflations. When the central bank
prints money, the price level rises. When it prints
money rapidly enough, the result is hyperinflation.
 Cost push or supply side inflation:

 arise when firms respond to rising costs by increasing prices in order

to protect their profit margins or occur due to supply shocks.

Cost push or supply side inflation arises due to:

Component costs: e.g. an increase in the prices of raw materials and other

components. This might be because of a rise in commodity prices such as

oil, copper and agricultural products used in food processing.

Rising labour costs: caused by wage increases, which are greater than

improvements in productivity. Wage costs often rise when unemployment

is low because skilled workers become scarce and this can drive pay levels

higher cost of production.

Expectations of inflation: are important in shaping what actually happens to

inflation. When people see prices are rising for everyday items they get concerned

about the effects of inflation on their real standard of living.

Higher indirect taxes: for example a rise in the duty on alcohol, fuels and

cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of

demand and supply for their products, suppliers may choose to pass on the burden

of the tax onto consumers.

A fall in the exchange rate: this can cause cost push inflation because it leads to an

increase in the prices of imported products such as essential raw materials,

components and finished products

Monopoly employers/profit-push inflation: where dominants firms in a market

use their market power (at whatever level of demand) to increase prices well above

costs.
• Effects of Inflation:

1. Inflation can result in a redistribution of income & wealth from

creditors to debtors. It can also harm savers.

2. Hyperinflation seriously impairs the functioning of an economy

by causing credit markets to collapse & wiping out purchasing
power of accumulated savings.

3. Actions taken in anticipation of inflation can adversely affect

the economy. Buyers & sellers base their decisions, in part, on
the gains & loses they expect. This can affect the ss of & dd for
particular goods & services thereby distorting market prices.
4. Anticipated inflation can distort consumer choices by
causing buyers to purchase goods now that they might
otherwise prefer to purchase in the future.
 Expansionary AD policies tend to produce inflation,
unless they occur when the economy is at high levels of
unemp’t.
 Inflation could be demand-pull (if high AD pushes prices
up) or cost-push (if adverse supply shocks are the typical
events that push up the costs of production).
 Benefit of moderate Inflation

a. Good for the growth of economy:

A mild or moderate inflation (up to 2% per year) is good for the growth

of economy because if there is no rise in price of goods or services than it

can lead to deflation which presents different set of problems for the

economy like recession or depression for the economy, vicious cycle of

lower consumption and lower production due to fall in price of goods and

services, unemployment and so on.

Perhaps that is the reason why countries all over the world if given a

choice between inflation and deflation would prefer inflation because

inflation if kept under control can boost the growth of the economy.
b. Moderate inflation enables adjustment of wages. It is

argued a moderate rate of inflation makes it easier to adjust

relative wages.

c. Increases productivity: Inflation though indirectly can

result in more productivity because when inflation rises
companies tend to increase their production so as to earn
more money and workers also work overtime because their
real wage has fallen due to inflation and to counter inflation
they have to increase their wages which can be done either
through overtime work or doing side job after work.
Trade-offs Between Inflation and Unemployment

The early idea for the Phillips curve was proposed in 1958 by economist

A.W. Phillips. In his original paper, Phillips tracked wage changes and

unemployment changes in Great Britain from 1861 to 1957, and found that

there was a stable, inverse relationship between wages and unemployment.

In 1960, economists Paul Samuelson and Robert Solow expanded this

work to reflect the relationship between inflation and unemployment.

Because wages are the largest components of prices so inflation could be

inversely linked to unemployment.

Two goals of economic policy makers are low inflation and low

unemployment, but often these goals conflict. Normally, there is

negative relationship between inflation rate and unemployment rate.

When unemployment rate is very low, then workers have the market

power to push up wages. Higher wage rate means that the cost of

production is high and so sellers change higher prices implying

higher inflation rate. When unemployment rate is very high, then

workers do not have much bargaining power; rather, they would be

ready to accept lower wage to get job. Therefore the pressure on

prices also remains low. This relation can be described by Phillips

curve shown below.

The Phillips curve is used to analyze the relationship between
inflation and unemployment.
The Phillips curve argues that unemployment and inflation are
inversely related: as levels of unemployment decrease, inflation
increases. The relationship, however, is not linear.
The Phillips curve has been used for macroeconomic policy analyses

which suggest that policymakers could choose different combinations

of unemployment and inflation rates.

The curve suggests that less unemployment can always be attained by

incurring more inflation and that the inflation rate can always be

reduced by incurring the costs of more unemployment.

In other words, the curve implies that there is a trade- off between

policies to reduce inflation and that intended to reduce unemployment.

The Long-Run Phillips Curve
Friedman and Phelps concluded that inflation and unemployment
are unrelated in the long run.
As a result, the long-run Phillips curve is vertical at the natural
rate of unemployment. Monetary policy could be effective in the
short run but not in the long run.
• In the long run, unemployment always returns
to the natural rate of unemployment, making
cyclical unemployment zero and inflation
equal to expected inflation.
 Macroeconomic Policies Instruments

Macroeconomic policy aims to provide a stable economic

environment that is conducive to achieve macroeconomic
goals such as high and stable economic growth, low
unemployment and inflation, Achieve Balance of
Payments Equilibrium and stable exchange rate.

Macroeconomic Policies Instruments are an economic

variable under the control of government that can affect one
or more of the macroeconomic goals.
Fiscal Policy, its Instruments and Effects

Fiscal Policy: deals with changes in government expenditures and/or taxes to

achieve particular economic goals, such as low unemployment, stable prices,

and economic growth.

Fiscal policy is the use of government expenditures and taxes to affect

aggregate demand and aggregate supply.

When government deliberately change in government expenditure and

taxation so as to achieve a certain macroeconomic goal, fiscal policy is said to

be discretionary fiscal policy.

In contrast, a change in either government expenditures or in taxes that

occurs automatically in response to economic events is referred to as

automatic fiscal policy.

Fiscal policy can be either contractionary or expansionary
fiscal policy.

a. Contractionary fiscal policy: is undertaken by reducing

government expenditure and increasing taxation. This
policy used to slow down spending, economic growth as
well as high inflation.

b. Expansionary fiscal policy: is undertaken by increasing

government expenditure and reducing taxation. And it is
used to combat unemployment and increasing output.
Government expenditure: includes government spending on goods

and services. It determines the relative size of the public and private

sectors.

Tax: Taxation affects the overall economy in two ways:

Taxes tend to reduce the amount people spend on goods and services

Taxes affect market prices, thereby influencing incentives and

behaviourur

Note: The taxation and public expenditure policies are also jointly

called as ‘budgetary policy.’

 Monetary Policy, its Instruments and Effects

Monetary Policy: is a deliberate manipulation or

change in money supply and interest rate to bring

about desirable change in the economy.

Monetary policy determines the money supply as

well as interest rates, in order to achieve desired

economic objectives.
Generally there are three tools of monetary policy

Open market operations (OMOs): is selling and buying of bonds,

treasury bills, securities by the national bank to increase or decrease

money supply in the economy.

Change in discount rate (r): is changing the discount rate (the interest

rate commercial banks pay to borrow money from the central bank

(national bank) to affect the money supply and interest rate.

Change in reserve requirement (RR): is changing the reserve rate

required by national bank. Required reserve ratio- is the portion of

commercial banks total deposit that are required to put in the national

bank.
 Similar to fiscal policy, monetary policy also classified in
to two, namely expansionary and contractionary.
Expansionary monetary policy: the policy intends to
increase the money supply and decrease in interest rate.
Includes:
Purchasing bonds and treasury bills
Decreasing discount rate and decreasing the required
reserve.
Contractionary monetary policy: the policy intends to
decrease the money supply and increase interest rate. It
includes
Selling bonds and treasury bills,
Increasing discount rate and increasing the required
reserve rate.
 Easy (Expansionary) Vs Tight (Concretionary) monetary policy
MONETARY POLICY: MAINSTREAM INTERPRETATION
(1) (2)
Easy money policy Tight money policy
Problem: Unemployment and Recession Problem: Inflation
Federal reserve buys bonds, lowers reserve ratio, Federal reserve sells bonds, increases reserves
or lowers the discount rate ratio, or increases the discount rate

Money supply rises Money supply falls

Interest rate falls Interest rate rises

Investment spending increases Investment spending decreases

Aggregate demand increases Aggregate demand decreases

Real GDP rises and UE decreases Inflation declines

1. what is natural rate of unemployment
2. if you governor of central bank of Ethiopia and Ethiopia face
unemployment and inflation what measures do you take
keep policy option turn by turn
3. explain the relationships between inflation and
unemployment in the short run and long run
4. discus the cause of inflation
5. Discus macroeconomic policies