CHAPTER TWO

2.0 NATIONAL INCOME ACCOUNTING

The aggregate performance of a large and complex economic system requires some

standards by which to measure that performance. Unfortunately, our systems of

national income accounting are imperfect and provide only rough guidelines,

rather than clear measurements of the economic performance of large systems. As

imperfect as the national income accounting methods are, they are the best

measures we have and they do provide substantial useful information. The purpose

of this chapter is to present the measures we do have for aggregate economic

performance.

In this chapter mainly we focus on the three statistics that economists and

policymakers use most often. Gross domestic product, or GDP, tells us the nation‘s

total income and the total expenditure on its output of goods and services. The

consumer price index, or CPI, measures the level of prices. The unemployment rate

tells us the fraction of workers who are unemployed. We see how these statistics

are computed and what they tell us about the economy.

2.1 The Concepts of Gross Domestic Product and Gross National Product

Gross Domestic Product (GDP)

Up to now, we have been somewhat careless in using the phrase ―domestic

product.‖ Let‘s now get more specific. Of the various ways to measure an

economy‘s total output, the most popular choice by far is the gross domestic

product, or GDP for short—a term you have probably encountered in the news

media. GDP is the most comprehensive measure of the output of all the factories,

offices, and shops in a given country. To compute GDP for a given economy, it will

Lecture Note for Accounting Students 23

be helpful to have a more precise definition: gross domestic product (GDP) is the

market value of all final goods and services produced within an economy in a given

period of time.

Several features of this definition need to be underscored.

i. First, the possibility of using money values of things

The GDP consists of a combination of variety of goods and services: computer chips

and potato chips, tanks and textbooks, and so on. How can we combine all of these

into a single number? To an economist, there is a natural way to do so: First,

convert every good and service into money terms, and then add all the money up.

Thus, we can add apples and oranges together. To add 10 apples and 20 oranges,

first ask: How much money does each cost? If apples cost 20 cents and oranges

cost 25 cents, then the apples count for $2 and the oranges for $5, so the sum is

$7 worth of ―output.‖

The market price of each good or service is used as an indicator of its value to

society for a simple reason: Someone is willing to pay that much money for it. This

decision raises the question of what prices to use in valuing different outputs. We

have two choices on this regard. Most obviously, we can value each good and

service at the price at which it was actually sold. If we take this approach, the

resulting measure is called nominal GDP or GDP in current prices. This seems like a

perfectly sensible choice, but it has one serious drawback as a measure of output:

Nominal GDP rises when prices rise, even if there is no increase in actual

production. For this reason, we have devised alternative measures that correct for

inflation by valuing goods and services produced in different years at the same set

of prices. We call it real GDP or GDP in constant dollars. The news media often

refer to this measure as ―GDP corrected for inflation.‖ We have a detailed

discussion of these alternatives in section 2.4.

Lecture Note for Accounting Students 24

 ii. What gets counted in GDP?

The next important aspect of the definition of GDP is that the issue of what gets

counted in GDP.

a. In a given period of time: the GDP for a particular year includes only goods

and services produced within that year. Sales of items produced in previous

years are explicitly excluded. The same is true of houses. The resale values of

houses do not count in GDP because they were counted in the years they

were built.

b. Final goods and services: Next, you will note from the definition of gross

domestic product that only final goods and services (are those that are

purchased by their ultimate users (consumers)) count in the GDP. The

adjective final is the key word here.

For example, suppose that a loaf of bread (a final good) is produced with

flour (an intermediate good). It would not make sense to add the value of

flour separately in the calculation of GDP since the flour has been ‗consumed‘

in process of making bread and since the market price of bread already

reflects the value of the flour that was used in its production. Thus, GDP

excludes sales of intermediate good and service (is a good purchased for

resale or for use in producing another good) because, if they were included,

we would wind up counting the same outputs several times ―double

counting.‖

The concept is straightforward, but the measurement problems can be

complex. For example, a given product, say, sugar, can be used as a final

product or as input into further production processes. Thus, this requires a

mechanism for distinguishing between the sugar bought for household

consumption and the sugar purchased for further production.

c. Domestic economy: The adjective domestic in the definition of GDP denotes

production within the geographic boundaries of a given country. For

Lecture Note for Accounting Students 25

 example, some Ethiopians work abroad, and some of them have offices or

factories in foreign countries. Although all of these foreign employees of

Ethiopian firms produce valuable outputs, none of it is counts in the GDP of

Ethiopia. (It counts, instead, in the GDPs of the other countries.) On the

other hand, quite a lot foreign companies produce goods and services in

Ethiopia. All that activity of foreign firms on our soil does count in our GDP.

d. Underground economy and nonmarket transaction: For the most part, only

goods and services that pass through organized markets count in the GDP.

This restriction, of course, excludes many economic activities. For example,

illegal activities are not included in the GDP. This reflects the inability to

measure the value of many of the economy‘s most important activities, such

as housework, repairs, and others. These activities certainly result in

currently produced goods or services, but they all lack that important

measuring rod—a market price.

Gross National Product (GNP)

One could alternatively define an economy as consisting of all production units that

belong to a country (whether or not these production units reside in the country

or not). For an economy defined in this way, the value of production is called the

Gross National Product (GNP). It is the most comprehensive measure of a nation‘s

productive activities. It is defined as the value of all final goods and services

produced by citizens of a country during a specific period, usually one year,

irrespective of their place of residence. It refers to that part of the GDP that is

actually produced and earned by or transferred to resident nationals of that

country. It measures output produced by the labor and property of citizens,

regardless of where the labor and property are located. On contrary, earnings of

foreigners which arise out of their domestic economic activities are thus excluded.

Lecture Note for Accounting Students 26

For Ethiopians working abroad their income is included in the GNP of Ethiopia.

Where there is substantial foreign participation in the economy and a large part of

total domestic income is earned and repatriated by foreigners and foreign

companies as in many LDCs, GDP will be much larger than GNP. As a result

statistics of GDP growth may give a false impression of the economic performance

of a particular developing nation.

Required Reading:

Students are advised to read on

i. the circular flow of income before chapter two

ii. the ―stock‖ and ―flow‖ concepts and their difference

2.2 Approaches of Measuring National Income (GDP)

Before the discussion of approaches to measurements, it is important to discuss the

importance of measuring national income. The national income estimates provide

not only a single figure showing the national income, but also supply the detailed

figure with regard to the various components of the national income. It is both the

figure of national income and the details regarding its constituents that throw

light on the functioning and performance of the economy. The following are some

of the important uses of national income estimates.

i. Assists government in planning the economy. The account shows growth

or stagnation in the economy, alerting policymakers to the sort of action

which ought to be taken. Since national income accounts break the

performance of the economy down into its component parts, they

provide policymakers with specific information regarding the formulation

and application of economic policy.

Lecture Note for Accounting Students 27

 ii. Permits us to measure the level of production in the economy over a

given period of time and to explain the immediate causes of that level of

performance.

iii. By comparing the national income accounts over a period of time, the

long-run course (growth path) which the economy has been following can

be plotted.

iv. Help us to compare standards of living of different countries

Required Reading:

Students are advised to read on the two approaches of exchange rate

conversion approach and purchasing power parity approach to solve the

problem of using different currencies by the countries being compared.

v. As a measure of welfare and national development, real GNP per capita

may be rising over a period of time implying a rise in economic welfare

and economic development.

Once we have agreed on the importance of estimates of national account, next, we

discuss the three alternative approaches (methods) for measuring total output,

namely:

i. Expenditure Approach

ii. Income Approach

iii. Value Added or Output Approach

The Expenditure Approach

Expenditure approach-involves only counting the value of those transactions where

a commodity reaches its final destination. The market for consumer goods is by

implication the market where final goods and services are sold.

Lecture Note for Accounting Students 28

Measuring total output by the expenditure method involves breaking down total

spending on all goods and services produced into four categories:

i. Expenditures by consumers on goods and services (abbreviated simply to the

letter, C);

ii. Expenditures by businesses on capital goods (total investment spending, I);

iii. Expenditure by government on goods and services, G); and

iv. Net exports (the total value of exports minus the total value of imports, X-M).

Because all spending done in the country falls into one or other of these four

categories, we can say that total expenditure is the sum of C+I+G+(X-M). We now

examine each of these four main components of total spending.

Consumption (C)

Consumption spending is the total of all outlays made by households on final goods

and services. In all countries it is by far the largest component of total spending. It

covers spending on an enormous range of items, including durable goods like

television sets and cars, non-durable goods like food and clothing, and personal

services such as legal advice, haircut, doctor visit, and dental care. But it usually

excludes spending on houses, which is customarily (and arbitrarily) treated as

investment expenditure. Consumption also excludes purchases of second-hand

goods that were produced in some earlier accounting period so as not to double

count the value of such output.

Investment (I)

Investment is the production of goods that are not for immediate consumption.

These goods are called investment goods (inventories and capital goods including

residential housing). The total investment in an economy is called Gross Investment.

Lecture Note for Accounting Students 29

Total or gross investment Expenditure may be divided into three main categories:

i. Expenditure on capital goods (business fixed investment): purchases of

plant and equipment either to replace existing capacity that is wearing

out or to increase capacity. This is often called fixed capital formation.

ii. Residential investment: We count the construction of new houses as part

of GDP, but we do not add trade in existing houses. We do, however,

count the value of the estate agents commission in the sale of existing

houses as part of GDP. The estate agent provides a current service in

bringing buyer and seller together, and that is appropriately part of

current output.

iii. Expenditure on inventories: Many businesses find it convenient or

necessary to hold certain supplies of goods on hand, in which case

investment in inventories may be considered voluntary. But business

conditions are uncertain and so firms may also find themselves holding

stocks because they miscalculated demand. In either case, firms are

considered to be investing when they accumulate inventories. On the

other hand, if their inventories decrease they are "disinvesting." Inventory

investment is highly volatile, changing greatly in amount and composition

from year to year.

Required reading:

Students are advised to read on ―real investment‖ and ―financial investment‖

Gross investment, then, is the total amount of (usually private) spending during

the accounting period on capital goods (defined as structures, machinery and

equipment, and inventories). Because capital by its nature consists of things that

are used in the production of other goods and services, it is inevitable that it will

wear out or "depreciate." The amount necessary for replacement is called

Depreciation or capital consumption allowance. Gross Investment – Depreciation =

Lecture Note for Accounting Students 30

Net Investment. Unless it is continually renewed, the stock of capital in the

economy will gradually be depleted.

Handling depreciation is one of the more difficult parts of national income

accounting. Again, the best treatment depends on what the data are meant to be

used for. If the concern is with the long-term growth of the economy, net

investment (total investment during the accounting period minus depreciation) is

the important concept because it measures the growth of the economy‘s capital

stock over time. But if the purpose is to understand short term, annual

fluctuations in the level of total spending it is better to work with gross

investment.

Government Expenditure on Goods and Services (G)

All governments, federal, regional and local governments, payments to factors of

production in return for factor services rendered are counted as part of the GDP.

Much of the spending done by governments in the developed countries today takes

the form of simple transfers of income from taxpayers to those eligible for the

wide range of income supplements available to assist the elderly, the sick and the

unemployed, or as payments of interest to holders of the public debt. Because such

transfer payments reallocate existing income and are not made in exchange for

goods and services, they are not part of GDP. What is counted is government

spending on goods and services, many of which are bought by the government on

behalf of the public and which are ultimately "consumed" by households: education,

health care services, national defense, roads, water and sewage systems, postal

services.

Thus, if you receive a wage from the government because you are a teacher, your

wage is a factor payment and would be included in GDP. If you receive a welfare

Lecture Note for Accounting Students 31

payment because you are poor, the payment is not in return for service but is a

transfer payment and would be excluded from GDP.

The same holds true for interest payment on the government debt. Interest is

treated as a payment for debt incurred to pay for past wars or government

programs and is not considered to be a purchase of a current good or service.

Government interest payments are considered as transfers and therefore omitted

from GDP.

Thus, do not confuse the way the national accounts measure government spending

on goods and services (G) with the official government budget. When the Treasury

measures its expenditures, it includes purchase of goods and services (G) plus

Transfers.

There are two complications concerning government expenditures:

i. Because so many of these goods and services are provided "free" or in

other ways that bypass markets, it is difficult to determine their value in

the same way that the value of the other items entering into C would be

determined. Consequently, national income accountants value

government spending on the basis of what the government pays for the

goods and services it requires- based on imputed value at cost of

providing services.

For example, police officers, firefighters, and city mayor provide services

to the public. Giving a value to these services is difficult because they are

not sold in a marketplace and therefore do not have a market price. The

national income accounts include these services in GDP by valuing them

at their cost. That is, the wages of these public servants are used as a

measure of the value of their output.

ii. Government expenditure on goods and services is that such spending is

often done on things like highways which are capable of being used to

assist in the production of other goods. Logically, such spending should be

Lecture Note for Accounting Students 32

 thought of as investment spending. Some countries produce their

accounts in such a form that government spending can be separated into

two categories, current spending on goods and services, and investment

spending.

Net Exports (X-M)

The External Sector Exports (X) represents an addition to domestic expenditure

and must be added to it in order to arrive at an indication of aggregate demand

or aggregate expenditure. Imports (M) are a subtraction from domestic

expenditure. An increase in imports (M) lowers aggregate demand and hence

employment whereas a rise in exports (X) has the opposite effect.

For example, production differs from sales in Ethiopia in two respects. First, some

of our production (coffee and oil seeds) is bought by foreigners and shipped abroad,

and these items constitute our exports. Second, some of what we consume

(Arabian oil and Indian car) is produced abroad and shipped to Ethiopia, and such

items are Ethiopian Imports.

A significant part of total spending in most countries goes toward the purchase of

goods produced abroad rather than domestically. As noted in discussing the

circular flow, such outlays represent spending which leaks from the domestic

economy to the rest of the world and is consequently treated as a negative entry

in measures of total domestic spending. But it is offset to a greater or lesser degree

by the spending of non-residents on goods produced and exported to international

markets. It is often convenient, therefore, to take domestic spending on imports

and foreign spending on exports as a combined value, usually called net exports, a

value which may be positive or negative in any accounting period depending on

which component, exports or imports, is larger.

Lecture Note for Accounting Students 33

 Summing these four expenditure components, C+I+G+(X-M), gives a single figure,

the total amount of spending done in the economy during the accounting period.

GDP = Y = C+I+G+(X-M)

Numerical Examples

1. We can use a simple farming economy to understand how the national

accounts work. Suppose that out of the total amount produced and 7

imported, 87 quintals are consumed (in C), 10 go for government purchases

to feed the army (as G), and 6 go into domestic investment as increases in

inventories (I). In addition, 4 quintals are exported.

What, then, is the composition and amount of GDP of this agrarian

economy?

GDP= 87 of C + 6 of I + 10 of G + (4 of X – 7 of M)

GDP=100 quintals

2. Suppose the following describes the economy (all figures in billions)

Personal Consumption Expenditure (C) 3658.10

Gross Private Domestic Expenditure (I) 745
Government Purchases of Goods & Services (G) 1098
Export 670
Import 708
What is the value of GDP?

GDP = C + I + G + NX

GDP = 3658.10 + 745 + 1098 + (670-708)

GDP = 5463.10

3. Suppose the following describes the economy (all figures in billions)

GDP 9000 birr

Investment 1500
Consumption 5000

Lecture Note for Accounting Students 34

 Government purchases of goods and services 1000

What is the value of net export?

GDP= C + I + G + NX

9000 = 5000 + 1500 + 1000 + NX

NX = 9000- 7500

NX = 1500 birr

Income Approach

Income approach involves calculation of GDP by summing up all incomes that

derived from the production process. In other words, it includes all payments

made in respect of the four factors of production, namely labor, capital, land and

entrepreneurship over a given period of time. This implies that the total of all

wages and salaries, interest, rent and profits is conceptually equal to the GDP as

calculated according to the production method.

In principle output expressed in monetary terms must be equal to the total

monetary income deriving from it (i.e. value of final goods and services = Total

income). As in the circular flow, what the firms producing the national output see

as costs of production, owners of productive factors see as income. Factor costs and

factor incomes are consequently the same thing viewed from different perspectives.

The national income accounts divide incomes into five categories: compensation of

employees, rental income, proprietors‘ income, net interest, and corporate profits.

Compensation of employee is the most important and certainly the simplest factor

costs to measure. It is the payments that made by employers for labor services.

These payments are include Wages, salaries, and supplementary labor income

which referring to employee benefits such as pensions, workers‘ compensation

benefits, and employer contributions to unemployment insurance funds or other

Lecture Note for Accounting Students 35

worker social security schemes. Rental income is the income that received for

owning property by property owners. It includes rent payments received by

landlords, royalty payments from patents and copy rights as well as imputed rent

that homeowners ―pay‖ to themselves. Similarly, the household receive interest

income for exchange in capital. The net interest is the interest that the domestic

businesses pay minus the interest they receive.

Profit is a residual left after paying for rent, interest on debt, and employees‘

compensations and other costs. There are two kinds of profits in national income

accounts: earning of incorporated enterprises (proprietors‘ income) and profit of

corporation (corporate profit). Proprietors‘ income consists of earning of

partnership and single owned business firms or earning of incorporated businesses

in general. Finally, corporate profit is the income of corporations after payments

to their workers and creditors. It includes corporate profit taxes, dividends, and

undistributed corporate profits; the latter is what corporations retained in to

business and is called ‗net corporate saving.‘

The sum of these five income components gives as the net domestic income at

factor cost. But if this figure for factor costs or income is compared with the total

arrived at by the expenditure method, it falls considerably short of the amount

expected. Thus, two adjustments must be made to get GDP at market prices:

i. Indirect taxes minus subsidies are added to get from factor cost to

market prices. In order to estimate GDP at market price it is therefore

necessary to add indirect taxes to GDP at factor cost, since the market

price exceeds GDP at factor cost by this amount. Similarly, subsidies are

paid to the producer and therefore form part of factor income but not of

the market price; for this reason it is subtracted from GDP at factor cost

to reach at GDP at market price. We therefore have to add indirect taxes

from the GDP at factor costs and deduct subsidies.

Lecture Note for Accounting Students 36

 ii. Depreciation (or capital consumption allowance) is added to get from net

domestic product to gross domestic product.

GDP at market price = Net domestic product at factor cost +

Indirect business taxes -
Subsides
C + I + G + (X-M) = Compensation of employees +
rental income +
proprietors‘ income +
net interest +
corporate profits +
Indirect business taxes -
Subsides
Numerical examples

1. Suppose the following describes the economy (all figures in billions)

Compensation of employees 3244.20

Proprietor‘s income 402.40
Rental income of persons 6.70
Corporate profits 297.10
Net interest 467.10
Deprecation 575.70
Indirect business taxes (IBT) 469.90
a. What is the value of net domestic product at factor cost?

b. What is the value of GDP at market price?

Solution:

a. Net domestic product = compensation of employees + rental income +

proprietors‘ income + net interest + corporate profits

= 3244.20 + 6.70 + 402.40 + 467.10 + 297.10

= 4417.50

b. GDP at market price = net GDP at factor cost + indirect business taxes +

Lecture Note for Accounting Students 37

 Deprecation

= 4417.50 + 575.70 + 469.90

= 5463.10

2. Suppose the following describes the economy (all figures in billions)

Transfer Payments $54

Interest Income (i) $150
Depreciation $36
Wages (W) $67
Gross Private Investment $124
Business Profits (PR) $200
Indirect Business Taxes $74
Rental Income (R) $75
Net Exports $18
Net Foreign Factor Income $12
Government Purchases $156
Household Consumption $304
a. Find GDP using expenditure approach

b. Find GDP using income approach

c. Compare the GDP values obtained using income and expenditure

approaches.

Solution:

a. GDP using expenditure approach

GDP = household consumption + Gross private investment + government

purchases + net exports

GDP = 304 + 124 +156 + 18 = 602

b. GDP using income approach

GDP = wages + rental income + interest income + business profit +

indirect business taxes + depreciation

= 67 + 75 + 150 + 200 + 74 + 36

= 602

Lecture Note for Accounting Students 38

 c. Both approaches yield the same level of GDP, which is true by the

definition.

Output or the Value Added Approach

A third method is available for estimating the total output of the economy and it

is called the "value added method" because it simply sums the net value (value

added) of the output produced by all firms in the economy. This approach

measures GDP in terms of values added by each sector of economy.

There are many interactions among firms in a modern economy. Many produced

goods are sold not to final users as consumer goods, but to other firms. Consider a

firm producing power supply devices for computers. It buys components from

suppliers, assembles them, and sells the finished product to another firm which

incorporates it into a computer. If the value of the power supplies was measured

when they were produced and again as part of the price of the finished computer,

total output would obviously be exaggerated.

The value added by any one business is equal to the total value of the firm‘s

products minus that value of the materials and intermediate goods the firm

purchases. In computing value added from the start to finish, each intermediate

good and service enters the calculation twice: once with the plus sign, when the

value added of the business that made the good is calculated, and once with a

minus sign, when the value added of the business that uses the good calculated.

Using this value-added approach, every good and service in the economy cancels

out except those that are sold to other businesses for use in the production process.

The goods whose values do not cancel out are the final goods and services-

consumption goods, goods purchased by the government, goods purchased as part

of investment, and net exports. In formula terms:

Value Added = output of firm - output purchased from other firms as input

Lecture Note for Accounting Students 39

If we follow the course of this process, we will see that the sum of values added at

each stage of process is equal to the final value of the item sold.

Numerical Example

1. Consider the following bread production process:

Stages of production Sales receipts Cost of intermediate products

Wheat 100 0
Flour 200 100
Final product: bead 300 200
a. Find the value added at each stages of production

b. Find GDP using value added approach

c. Find GDP as the value of final product

Solution:

a. Value at each stage of production can be obtained by subtracting sales

receipt from cost of intermediate products

Stages of Sales Cost of intermediate Value added

production receipts products
Wheat 100 0 100-0 = 100
Flour 200 100 200-100 = 100
Final product: bead 300 200 300-200 = 100
Total 600 300
b. GDP using value added approach = (100-0) + (200-100) + (300-200)

=300

c. GDP at the value of final product= 300.

2. The small economy of Pizzania produces three goods (bread, cheese, and

pizza), each produced by a separate company. The bread and cheese

Lecture Note for Accounting Students 40

 companies do not buy inputs. The pizza company uses the bread and cheese

from the other companies to produce pizza. All three companies use capital

and labor to produce output.

Input/ Bread Cheese Pizza

output company company company
Input costs 0 0 50(bread), 35(cheese
Wages 15 20 75
Interest 20 10 20
Value of output 50 35 200
a) Calculate GDP using the value added approach

b) Calculate GDP using the expenditure approach

c) Calculate GDP using the income approach

d) Do your GDP estimates agree? Why or why not?

Solution:

a) GDP = (50-0) + (35-0) + (200-50-35) = 50 + 35 + 115 = 200

b) Using expenditure approach GDP is value of final product

GDP = value of final product Pizza

GDP = 200

c) GDP = (15+20+(50-20-15-0))+(20+10+(35-10-20-0))+(75+20+(200-

75-20-(50+35)))

= (15+20+15) + (20+10+5)+(75+20+(200-75-20-85))

= 50 + 35 + (75 + 20 + 20)

= 50 + 35 + 115

= 200

d) Yes, they should be by definition.

2.3 Other Social Accounts (GNP, NNP, NI, PI and DI)

Lecture Note for Accounting Students 41

The national income accounts include other measures of income that differ slightly

in definition from GDP. It is important to be aware of the various measures,

because economists and the press often refer to them.

To see how the alternative measures of income relate to one another, we start

with GDP and add or subtract various quantities.

Gross National Product (GNP): GNP measures the total income earned by residents

of an economy from engaging in various economic activities, irrespective of

whether the economic activities are carried out within the economic territory or

outside, in a specified period of time, usually one year.

To obtain gross national product (GNP), we add receipts of factor income (wages,

profit, and rent) from the rest of the world and subtract payments of factor

income to the rest of the world:

GNP = GDP + Factor Payments from Abroad − Factor Payments to Abroad

GNP = GDP + Income earned by residents outside the economic territory -

Income earned by non-residents

GNP = GDP + Net Factor Income from abroad (NIA)

Under what situation GDP is greater than GNP? GDP becomes greater than GNP

when income earned by non-residents locally is greater than income earned by

residents abroad, or when NIA is negative.

Net National Product (NNP): To obtain net national product (NNP), we subtract

the depreciation of capital—the amount of the economy‘s stock of plants,

equipment, and residential structures that wears out during the year:

NNP = GNP − Depreciation.

Lecture Note for Accounting Students 42

In the national income accounts, depreciation is called the consumption of fixed

capital. Because the depreciation of capital is a cost of producing the output of the

economy, subtracting depreciation shows the net result of economic activity.

National Income (NI): The next adjustment in the national income accounts is for

indirect business taxes, such as sales taxes. These taxes place a margin between the

price that consumers pay for a good and the price that firms receive. Because

firms never receive this tax margin, it is not part of their income. Once we

subtract indirect business taxes from NNP, we obtain a measure called national

income:

National Income = NNP − Indirect Business Taxes

National income measures how much everyone in the economy has earned.

Personal Income (PI): A series of adjustments takes us from national income to

personal income, the amount of income that households and non-corporate

businesses receive. Three of these adjustments are most important.

i. First, we reduce national income by the amount that corporations earn

but do not pay out, either because the corporations are retaining

earnings or because they are paying taxes to the government. This

adjustment is made by subtracting corporate profits (which equals the

sum of corporate taxes, dividends, and retained earnings) and adding

back dividends.

ii. Second, we increase national income by the net amount the government

pays out in transfer payments. This adjustment equals government

transfers to individuals minus social insurance contributions paid to the

government.

iii. Third, we adjust national income to include the interest that households

earn rather than the interest that businesses pay. This adjustment is

made by adding personal interest income and subtracting net interest.

Lecture Note for Accounting Students 43

Thus, personal income is

Personal Income = National Income

− Corporate Profits

− Social Insurance Contributions

− Net Interest

+ Dividends

+ Government Transfers to Individuals

+ Personal Interest Income.

Disposable Income (DI): Next, if we subtract personal income tax payments and

certain non-tax payments to the government (such as parking tickets), we obtain

disposable personal income.

Disposable Personal Income

= Personal Income − Personal income Tax and Nontax Payments

Disposable personal income is the amount the households and non-corporate

businesses have available to spend after satisfying their tax obligations to the

government.

Numerical Example

Using the following data calculate GDP, GNP, NNP NI, PI, and DI

Undistributed corporate profits 40

Personal consumption expenditures 1345
Compensation of employees 841
Net interest 142

Lecture Note for Accounting Students 44

Export 60
Indirect business taxes 90
Government expenditures 560
Government transfers to individuals 60
Rental income 115
Personal income taxes 500
Imports 75
Proprietors income 460
Personal interest income 10
depreciation 80
Corporate income taxes 100
Net investment 120
Dividends 222
Net income earned from abroad 5
Social security contributions 70
Solution

i. GDP using expenditure approach

GDP= personal consumption expenditures + gross private domestic

investment + government expenditures + (gross export – gross import)

GDP = 1345 + (120 + 80) + 560 + (60-75)

GDP = 1345 + 200 + 560 + (-15)

GDP = 2090

GDP using income approach

GDP = (compensation of employees + rents + interest + proprietors

income + (corporate income taxes + dividends + undistributed corporate

profits)) + (indirect business taxes-Subsidies) + depreciation

GDP = (841 + 115 + 142 + 460 + (100 + 222 + 40) + (90-0) + 80

GDP = (841 + 115 +142 + 460 + 362) +90 +80

GDP = 1920 + 90 + 80

GDP = 2090

Lecture Note for Accounting Students 45

 ii. GNP = GDP + Net factor income from abroad (NFIA)

GNP = 2090 + 5 = 2095

iii. NNP = 2095 – 80 = 2015

iv. NI = NNP − Indirect Business Taxes

NI = 2015- 90

NI = 1925

v. PI = NI − Corporate Profits − Social Insurance Contributions − Net

Interest + Dividends + Government Transfers to Individuals + Personal

Interest Income

PI = 1925 – 362 – 70 – 142 + 222 + 60 + 10 = 1643

vi. DI = PI – Personal income taxes

DI = 1643 – 500 = 1143

2.4 Nominal versus Real GDP

We have defined GDP as the dollar value of goods and services. In measuring the

birr value of GDP, we have used the measuring rod of market prices for the

different goods and services produced. But prices change over time, as inflation

generally sends prices upward year after year. This problem of changing prices is

one of the problems that economists have to solve when they use market price as a

measuring rod (yardstick). Thus, they have to replace with a reliable measure by

removing the price-increase components so as to create a real or quantity index of

national output.

Here as a basic idea two measures of GDP are known: nominal GDP (also called

current dollar GDP) and real GDP (constant dollar GDP). Nominal GDP measures

the value of output at the prices prevailing at the time of production, while real

GDP measures the output produced in any one period at the prices of some base

year. The real GDP is calculates the real change in the level of output after

removing the influence of change in prices or inflation. In other word, nominal

Lecture Note for Accounting Students 46

GDP is calculated using changing prices, while real GDP represents the change in

the volume of total output after price changes are removed.

The countries could have their own base year prices. In Ethiopia, the Ministry of

Finance and Economic Development (MOFED) has changed the base year for

estimation of real GDP to the year 2010/2011 (2003 Ethiopian Financial year).

According to MOFED, a more recent base year is considered with a view to

incorporate structural changes in economy.

To make the idea more clear lets consider one hypothetical country producing only

three products namely teff, soft drink, and machinery. The amounts of production

and the prices of two years are presented in the following table.

Production 2010/11 2011/12

Price Quantity Price Quantity

Teff 1000 100 1200 100

Soft drink 7 75 8 75

Machinery 2000 25 2500 25

The nominal GDP of each year can be computed by multiplying the amount

produced with the price of commodity prevailing at the time of production.

( ) ∑

( )
( ( )( )
( ( )( )
( ( )( )

( ) ( )( ) ( )( ) ( )( )

Similarly, for 2011/12

Lecture Note for Accounting Students 47

 ( )
( ( )( )
( ( )( )
( ( )( )

( ) ( )( ) ( )( ) ( )( )

Taking these values of nominal GDP it is possible to estimate the growth rate

between 2010/11 and 2011/12. For this purpose the following formula can be

applied.

( ) ( )
( ) ( )
( )

( ) ( )
( )

But if we compare the level of outputs for three items, all have equal amount of

output. It clearly indicates that use of nominal GDP for comparative analysis is

usually misleading. Applying a certain constant price in different time horizon

solves the problem of change in price. Using the price of 2010/11 for both years,

the GDP of two years would be identical.

( )
( )( )
( )( )
( )( )

( ) ( )( ) ( )( ) ( )( )

Similarly, for 2011/12

( )
( )( )
( )( )
( )( )

( ) ( )( ) ( )( ) ( )( )
Lecture Note for Accounting Students 48
Now, if we make comparisons of the GDP of 2010/11 with 2011/12, the GDP

grew at 0 percent, which is logically true.

( ) ( )
( ) ( )
( )

( ) ( )
( ) ( )
( )

( ) ( )

( )

In the presence of inflation, the nominal GDP may overestimate value of physical

output during the year. In this case, Real GDP resolves overestimation, since it uses

a constant market price of the base year. In other word, Real GDP resolves the

problem of overestimation by eliminating the change in the price level from the

nominal GDP. Thus, real GDP is comparatively appropriate measure of the rate of

economic growth relative to nominal GDP.

2.5 Limitation of GDP as Indicator of Economic Welfare

GDP is a reasonably accurate and extremely useful measure of domestic economic

performance. It is not and was never intended to be, an index of social welfare.

GDP is simply a measure of the annual volume of market oriented activity.

Nevertheless, it is widely held that there should be a strong positive correlation

between real GDP and social Welfare, that is, greater production should move

society towards ―the good life‖. GDP includes many questionable entries and omits

of many valuable economic activities. Thus, we must understand some of the short

coming of GDP. Let us consider major points.

i. Exclusion of non-market transaction: recall that the standard accounts

only include primarily market activities. But much useful economc

Lecture Note for Accounting Students 49

 activities take place. For example, many household activities produce

valuable ―near-market‖ goods and services such as meals, laundering,

and child-care services. Because GDP calculation excludes the values of

such no-market transactions, it causes GDP to be underestimated.

ii. Omitted Leisure time: the value of leisure time (i.e. shorter working day

or week) is omitted for the GDP. On average, many Ethiopian want

spend as much of their time on utility-producing leisure activities as they

do on money-producing work activities. Yet the value of leisure time is

excluded from our official national statistics of GDP.

iii. Exclusion of underground economy: You might wonder about the many

activities in the underground economy, which covers a wide variety of

market activities that are not reported to the government. It includes a

wide variety of activities like gambling, prostitution, drug dealing, work

done by illegal immigrants, under invoice of import and export, street

vending, smuggling, and so on. Actually, much of underground activity is

intentionally excluded because the national output excludes illegal

activities-these are by social consensus ―bads‖ and not ―goods.‖ Thus, the

existence of this economy in the country causes the under estimation of

GDP for the reason that the traditional method of calculating GDP fails

to include goods and services produced in the underground economy.

iv. Omitted environmental damage: in addition to omitting activities,

sometimes GDP omits some of the harmful side effects of economic

activity. An important example is the omission of environmental

damages. When industrial firms growing, GDP of a country might

increase. However, GDP ignores the negative externalities that follow due

to industrial expansion on the neighborhood with air pollution in the

process of production.. Among others, the negative externalities include

noise, liquid and solid wastes, and so on. The exclusion of negative

externalities may lead to overestimated GDP.

Lecture Note for Accounting Students 50

 v. Improved product quality: GDP is a quantity, and not a qualitative

measure. It does not accurately reflect the improvement in product

quality. For example, there is a fundamental qualitative difference

between a personal computer purchased today and a computer that

bought just a few years ago. Failure to account for such quality

improvement is a sort coming of GDP accounting. Quality improvement

clearly affects the economic well-being as much does the quantity of

goods. Because product quality improved over time, GDP understates

improvement in material well-being.

vi. Ignore composition and distribution of output: change in composition of

goods and services and how output is distributed among the members of

society affects economic welfare. But GDP does not specify which goods

and services are produced as well as for whom it is distributed. GDP only

inform the birr value of the produced goods and services.

2.6 Measuring Inflation (Cost of Living)

The GDP Deflator and the Consumer Price Index

From nominal GDP and real GDP we can compute a third statistic: the GDP

deflator. The GDP deflator, also called the implicit price deflator for GDP, is

defined as the ratio of nominal GDP to real GDP:

The GDP deflator reflects what‘s happening to the overall level of prices in the

economy. To better understand this, consider an economy with only one good,

bread. If P is the price of bread and Q is the quantity sold, and then nominal GDP

is the total number of dollars spent on bread in that year, P × Q. Real GDP is the

number of loaves of bread produced in that year times the price of bread in some

base year, P base × Q. The GDP deflator is the price of bread in that year relative

Lecture Note for Accounting Students 51

to the price of bread in the base year, P/P base. Thus, GDP Deflator measures

price of a current year relative to price of a base year.

To make the idea more clear let consider the previous example of a hypothetical

country producing only teff, soft drink, and machinery. Under the previous

discussion we have computed both the nominal and real GDP as summarized in the

form of table as below.

Years Nominal GDP Real GDP

2010/11 150,525 150,525
2011/12 183,100 150,525

Using these computed values of nominal GDP and real GDP we can compute the

GDP Deflator for each year.

( )
( )
( )

( )

This result implies that at the base year, both nominal and Real GDP are equal and

the GDP Deflator always equal to 1 (or 100 in terms of percentage).

Similarly, for the year 2011/12 the GDP Deflator computed as

( )
( )
( )

( )

This result implies that the price in 2011/12 is 21.64 percent ((1.2164-1)*100)

relatively higher than that of 2010/11. It can be formally computed as below.

( ) ( )

( )

Lecture Note for Accounting Students 52

 ( )( )

( )( )

From this example it is possible to understand that GDP Deflator as a measure for

the price change (or inflation). The GDP deflator allows us to separate nominal

GDP into two parts: one part measures quantities (real GDP) and the other

measures prices (the GDP deflator). That is,

Nominal GDP = Real GDP × GDP Deflator

We can also rewrite this equation as

In this form, you can see how the deflator earns its name: it is used to deflate

(that is, take inflation out of) nominal GDP to yield real GDP.

The Consumer Price Index, CPI

The Consumer Price Index (CPI) is probably the most commonly cited index of

price. Just as GDP turns the quantities of many goods and services into a single

number measuring the value of production, the CPI turns the prices of many goods

and services into a single index measuring the overall level of prices.

CPI measures the price of a representative basket called CPI-basket of goods that

purchased by consumers. It is used to compare what a fixed basket of goods costs

this month with what it cost in some reference base period. The CPI-basket

contains basically all the goods and services consumed in a country like food, gas,

haircuts, transportation, house rent and so on. The composition of the CPI-basket

is determined by the value of what is consumed in the country- the larger the

Lecture Note for Accounting Students 53

value of total consumption of a good or service, the larger the weight in the basket.

For example, if we spend three times as much on food as on house, food will have

three times weight in the CPI-basket. Thus, the weights reflect the importance of

each good in the typical consumer‘s budget.

The exact details of the composition of the basket and how the CPI is calculated

are complicated and vary somewhat between countries. In Ethiopia, Central

Statistical Authority (CSA) has a job of computing the CPI. The CSA calculate and

report once a month. The CSA determines the market basket that used for CPI

calculation from periodic Consumer Expenditure Surveys, which are used to update

the weighting scheme about once in every five years. The recent compositions and

weights of items in the market basket are presented as in the following table.

(reference period: 2010/11 (2003 E.C.))

Content of Market Basket Weight in percent

1 Food and non-alcohol 53 %
Non-food items 47%
2 Alcohol, cigarettes, tobacco, nicotine 4.9%
3 Cloth and foot wear 6.6%
4 House rent, water, electricity, fuels, and 16.3%
construction materials
5 Furniture, furnishing, household equipment 5.4%
6 Medical care and Health expenses 1.1%
7 Transport 2.8%
8 Communication 1.1%
9 Recreation, entertainment and education 0.6%
10 Education 0.5%
11 Hoteling and restaurant 5.5%
12 Other material and services (miscellaneous good) 2.6%
Total 100
Source: CSA report, March 2012/13

Lecture Note for Accounting Students 54

How should economists aggregate the many prices in the economy into a single

index that reliably measures the price level? The CPI calculation has three steps:

i. Finding the cost of CPI-basket at the base period prices.

ii. Finding the cost of CPI-basket at current period prices.

iii. Calculating the CPI for the base period and the current period.

The next example shows a simplified CPI calculation in which we assume a base

period of 2010/11.

Let we use the pervious example to discuss how to compute the CPI.

Item Quantity Base-year price Subsequent-year price

(2010/11) (2011/12)
Teff 100 1000 1200
Soft Drink 75 7 8
Machinery 25 2000 2500
(a) The cost of CPI-basket at base period prices: 2010/11

CPI-market basket Cost of

Item Quantity price CPI-basket
Teff 100 1000 100,000
Soft Drink 75 7 525
Machinery 25 2000 50,0000
Cost of CPI-basket at base period prices 150,525
(b) The cost of CPI-basket at a current period prices: 2011/12

CPI-market basket Cost of

Item Quantity price CPI-basket
Teff 100 1200 120,000
Soft Drink 75 8 600
Machinery 25 2500 62,500
Cost of CPI-basket at a current period prices 183100
(c) The CPI for the base period and current period.

Lecture Note for Accounting Students 55

 ( )

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

For 2011/12, the CPI is: (183,100/150,525) (100) = 121.64

Alternatively, we can use the weighting approach to compute CPI. This the often

applied approach to measure the CPI once we have weight for each item in the

CPI-basket. In this case we need to apply the formula.

∑
()

Where current price of consumer good (i)

() base year price of good (i)

base year expenditure on good (i)

base year total expenditure

Let we introduce the concept of weighting using the pervious example.

For 2010/11, the CPI is:

( )( ) ( ) ( )

( ) ( ) ( )

For 2011/12, the CPI is:

( )( ) ( ) ( )

( ) ( ) ( )

Lecture Note for Accounting Students 56

Inflation rate over a period of time can be computed using the CPI as follows.

( )

( )

( )

But usually CPI give somewhat different information about what‘s happening to

the overall level of prices in the economy when compare with GDP deflator. There

are three key differences between the two measures of cost of living.

i. The first difference is that the GDP deflator measures the prices of all

goods and services produced, whereas the CPI measures the prices of only

the goods and services bought by consumers. Thus, an increase in the

price of goods bought by firms or the government will show up in the

GDP deflator but not in the CPI.

ii. The second difference is that the GDP deflator includes only those goods

produced domestically. Imported goods are not part of GDP and do not

show up in the GDP deflator. Hence, an increase in the price of a Toyota

made in Japan and sold in Ethiopia affects the CPI, because consumers

buy the Toyota, but it does not affect the GDP deflator.

iii. The third and most subtle difference results from the way the two

measures aggregate the many prices in the economy. The CPI assigns

fixed weights to the prices of different goods, whereas the GDP deflator

assigns changing weights. In other words, the CPI is computed using a

fixed basket of goods, whereas the GDP deflator allows the basket of

goods to change over time as the composition of GDP changes.

Lecture Note for Accounting Students 57

 In recent years there has been considerable discussion that implies that the CPI

overstates the ―true‖ increase in the cost of living. Since some components

living are not measured exactly, the CPI does not measure the cost of living

accurately. In this case the CPI is possibly a biased measure of cost of living. The

bias arise due to four potential sources, namely, new goods bias, quality change

bias, commodity substitution bias, and outlet substitution bias.

i. New Goods Bias: new goods do a better than old goods that they replace,

but cost more. This arrival of new goods puts an upward bias into the

CPI and its measure of the inflation rate.

ii. Quality change bias: better cars and televisions cost more than the

versions they replace. A price rise is a payment for improved quality and

it is not for inflation but might get measured as inflation.

iii. Commodity substitution bias: if the price beef raises faster that the price

of chicken, people buys more chicken and less beef. But the CPI-basket

does not change to allow for the effects of substitution between goods.

iv. Outlet substitution bias: if the prices rise more rapidly, people use

discount stores more frequently. But the CPI basket does not change to

allow for the effects of outlet substitution.

As a possible solution this can be reduced by deciding on how to increase the

frequency of Consumer Expenditure survey and the subsequent revision on the CPI-

basket. If this is not possible the bias has two main negative consequences on

private contacts and government outlays and taxes.

i. Distortion of private contacts: many wage contacts are linked to the CPI.

If the CPI is biased, these contracts might deliver an outcome different

from that intended by the parties. Suppose that WU sign a 3 years wage

deal: in the first year, the wage will be 30 birr an hour and will rise by

the assumed inflation rate in the next two years. If the assumed inflation

rate is 5 percent a year, the age rises to 31.50 birr an hour in the

Lecture Note for Accounting Students 58

 second year and 33.08birr an hour in the third year. But if the actual

inflation rate is 2 percent a year, the intended wages in the second and

third years are 30.9 birr an hour and 31.83 birr an hour. Here, what

the workers‘ gain is the loss for WU. With hundredth of workers, WU‘s

loss would be millions of birrs over the three years period.

ii. Increases in the government outlays and decreases in the taxes: major

portion of the federal government outlays are linked directly to the CPI.

The CPI is used to adjust social security benefit payments, pension

payments (for retired military personnel, federal civil servants, and their

spouses), budget for school lunches, and others.

The CPI is also used to adjust the income levels at which higher tax rates

apply. Because tax rates on large incomes are higher than those on small

incomes rise, the burden of taxes would rise relentlessly if these

adjustments were not made. To extent that the CPI is biased upward,

the tax adjustments over-compensate for rising prices and decrease the

amount paid in taxes.

Required reading:

Students are advised to read on alternative measures of the price level

―Producer Price Index (PPI)‖ and ―Personal Consumption Expenditures

Deflator (PCE deflator)‖

2.7 Measuring Joblessness: The Unemployment Rate

One aspect of economic performance is how well an economy uses its resources.

Because an economy‘s workers are its chief resource, keeping workers employed is

a paramount concern of economic policymakers. The measurement of the level of

national employment or unemployment rate requires classification of the concepts

like labour force, employed and unemployed.

Lecture Note for Accounting Students 59

Labour force means the sum of the number of the population in the working age

with jobs and those who are actively seeking job and /or available for work but

failed to find job. In other word, labour force refers to the supply of labor available

for the production of goods and services in an economy. It excludes the adult

population that is keeping house, retired, elderly, children, too ill to work, simply

not looking for work, or institutionalized individual (those in jail, military, and

those on education).

The total labour force is classified in to employed and unemployed. Employed are

people who perform paid work, as well as those who have jobs but are absent from

work because of illness, strikes, or vacations. Unemployed group includes people

who are not employed but are actively looking for work or waiting to return to

work. To be counted as unemployed, a person must do more than simply think

about work. A person must report specific efforts to find a job (such as having a

job interview or sending a resumes). In other word, unemployed refers to those

involuntary unemployed.

The prevalence of unemployment in an economy is usually measured using the

unemployment rate, which is defined as the percentage of those in the labor force

who are unemployed. Unemployment rate is one of the important macroeconomic

variables and the best single index to explain the performance of the economy and

the status of the labor market. The national unemployment given the total labour

force we have computes as:

Where the

Numerical examples:

1. The statistical report on the 1999 national labour force survey indicated

that 25,121,414 are employed while the remaining 500,761 are

Lecture Note for Accounting Students 60

 unemployed (CSA, 1999). Then find,

a. Total labour force

b. Unemployment rate

Solution

a.

b.

2. During the same period (1999) the ratio of employed male to unemployed

male was 67.219. Given this ratio find the unemployment rate for male

population.

Solution

Now it is possible to substitute the above given ration.

On the basis of their sources, there are various types of unemployment categories.

The most frequently stated types are demand deficient or cyclical, frictional,

structural, and seasonal unemployment. Still there are some additional types of

unemployment that are occasionally mentioned such as classical, hidden, and

underemployment or disguised unemployment. Real-world unemployment may

combine different types. Thus, distinguishing clearly one from the other and

measuring the magnitude of each of them is difficult, partly because they overlap.

Lecture Note for Accounting Students 61

Cyclical/Demand deficient/Keynesian unemployment arises from the business cycle

as a result of insufficient effective aggregate demand. Obviously, this type of

unemployment coincides with unused industrial capacity and as traditional

Keynesian economics suggests, it may possibly be addressed by adopting either

expansionary fiscal policy (deficit spending) or expansionary monetary policy.

Frictional /Search unemployment is transitional or temporary unemployment that

arises because a person may take time to find a new job after losing or quitting a

job, or after entering or reentering the labor force following schooling, illness, or

some other reason for being out of the labor force. It usually occurs due to

imperfect information in the labor market. It is common in any economy and

partially desirable as long as the switch from one job to another increases

individuals‘ welfare and economic efficiency.

Structural unemployment is caused by a mismatch between the workers looking

for jobs and the vacancies available. It is attributed to changes in geographical

location or skill variation or industrial structure of the economy. On the other

hand, Seasonal unemployment arises as employment condition changes over the

season of the year. It may be related to both supply side and demand side

seasonality.

High unemployment is both an economic and social problem. Unemployment is an

economic problem because it represents waste of a valuable resource. When workers

become unemployed, the output of a nation decreases. The nation loses output

which would be produced by unemployed workers. When unemployment occurs, it‘s

immediate impact rest on unemployed individuals. Consequently, a loss of job

implies a loss of income and thus consumption of unemployed individuals‘ declines.

Besides, due to high unemployment government lose tax income and producers lose

profit that would be generated form high level of production.

Unemployment is also a major social problem because it causes enormous suffering

as unemployed workers struggled with reduced level of their income. During the

Lecture Note for Accounting Students 62

periods of high unemployment, economic distress spills over to affect people‘s

emotions and family lives. While the unemployed population increases, drug abuse,

crime rate and related habit would be increase. These create social problems.

2.8 Business Cycle and the Relationship between Macroeconomic Variables

Economists have always followed the periodic changes that occur in level of business

activity. These fluctuations are called business cycles. In this section, we will briefly

define the term business cycle and describe some of its phases.

In a free enterprise economy, plans and decisions are made independently by a

large number of economic agents. From time to time, imbalances between supply

and demand will emerge and agents will not always be able to make the necessary

adjustments to remove the imbalance. The inability to foresee and plan for all

contingencies leads, on occasion, to an accumulation of imbalances throughout the

economy. Such aggregate fluctuations are called business cycles.

Business cycles are recurring changes in economic activity. They do not follow any

fixed periodic pattern such as seasonal cycles. Furthermore, each cyclical episode

can differ with respect to the duration, depth, and diffusion of the cycle.

Although each business cycle is unique, there are enough similarities to make some

general statements about the performance of the economy over the course of a

typical cycle. Let us enter the process with an economic expansion getting

underway.

The process of expansion can be fueled by a number of forces including an anti-

recessionary macroeconomic policy, foreign demand, underlying growth

expectations, and the inherent forces that bring a contraction to an end. The

latter can include the influence of low mortgage interest rates on housing demand.

Furthermore, low interest rates and the ready availability of skilled labor, plant

Lecture Note for Accounting Students 63

capacity, material inputs and credit may lead entrepreneurs with underlying

confidence in the economy to seize the opportunity and start new projects. Such

responses can go a long way to starting an expansion phase.

The expansion impulse will spread quickly through the economy. Increases in

earnings in the expanding sectors will generally lead to increased retail sales

throughout the economy. New orders will expand in all sectors and bring the

recession to an end. In the early phase of the expansion, output can be increased

with only small increases in employment. Thus, productivity growth (the growth of

output per labor hour) is likely to be rapid. As a consequence, profits are likely to

respond quickly.

As the expansion goes on, capacity constraints loom in the not-too-distant future

and delivery lags begin to lengthen. At the same time, interest costs and

equipment prices are favorable. Thus, contracts and orders for investment goods

begin to rise, and, with some lags, investment expenditures increase as well.

At this point, the expansion is well under way. GDP quickly surpasses its previous

peak and a mood of optimism spreads over the economy. There is a willingness to

undertake new activities and the expansion is self-reinforcing. Although there may

be pauses in growth due to brief inventory adjustments, the strength of consumer

demand and investor confidence can maintain an expansion for a long period of

time.

Nevertheless, forces that can generate a recession do appear, and if a few of them

come together, the expansion can reach its peak. First, as the expansion eliminates

all slack in the economy, shortages of key resources might create physical barriers

to further expansion. Second, as capacity is reached, costs of production will go up,

profit margins decline and productivity growth slows. Growth expectations and the

mood of optimism may begin to erode. Third, unless the monetary authority

accommodates all inflationary pressures, the expansion is likely to lead to increased

interest rates. Home building is often the first sector affected by interest rate

Lecture Note for Accounting Students 64

pressures. Fourth, a vigorous expansion may lead to a too rapid buildup of

inventories and capital goods. At this stage, the economy is perched precariously

between a slowdown in the expansion and a recession.

If the balance of contractionary forces grows, the economy will enter a recession.

After the peak of economic activity, many firms will find their inventories

expanding rapidly as demand falls. There are pressures on profits and many firms

might be experiencing financial difficulties. Cash flow might be insufficient to

service debt incurred during the expansion and the number of bankruptcies is likely

to increase. Once the contraction is clearly underway, unemployment will increase.

The forces of recession will also be self-reinforcing.

However, there are a number of forces that make recessions rather short phases.

First, consumption and investment plans are to a large extent determined by

long-run expectations. Second, competitive pressures lead firms to take advantage

of the recession to improve efficiency and increase market share. Third, the

depreciation of capital leads to new investment demand. Finally, policy-makers are

likely to take action to shorten a recession and this drives expectations. Thus, most

recessions come to an end within a year and before the toll of unemployment has

a major impact on the well-being of society.

Growth rate peak peak growth trend

Peak

Expansion contraction contraction

Contraction Trough

Trough expansion Time

This diagram shows a long-term growth (secular) trend that is substantially

positive (the straight, upward sloping line). About that secular trend is another

Lecture Note for Accounting Students 65

curved line, whose slope varies between positive and negative, this is much the

same as the business cycle variations about that long-term growth trend.

In general, a business cycle shows more or less regular pattern of expansion

(recovery), contraction (recession, and intermediate phases of peak as well as

trough. (see simplified diagram of business cycle below)

SUMMARY

1. GDP is the most comprehensive measure of the output of all the factories,

offices, and shops in a given country. It is the market value of all final goods and

services produced within an economy in a given period of time. Alternatively Gross

National Product (GNP) is the value of all final goods and services that produced

by citizens of a country during a specific period, usually one year, irrespective of

their place of residence.

2. Currently, there are three alternative approaches to calculate the GDP in

the economy namely expenditure, income and output (value added) approaches. All

the approaches give identical results. Expenditure approach determines GDP

through summing up of all types of spending on finished goods and services by four

major economic agents (households, businessmen, government, and foreign sector.

3. Income approach involves calculation of GDP by summing up all incomes

that derived from the production process. In other words, it includes all payments

made in respect of the four factors of production, namely labor, capital, land and

entrepreneurship over a given period of time. This implies that the total of all

wages and salaries, interest, rent and profits is conceptually equal to the GDP as

calculated according to the expenditure method.

Lecture Note for Accounting Students 66

4. Output (value added) approach measure GDP as the sum of the net value

(value added) of the output produced by all firms in the economy. This approach

measures GDP in terms of values added by each sector of economy.

5. Economists evaluate the success of an economy‘s overall performance by how

well it attains these objectives: (a) high level and rapid growth of output and

consumption; (b) low unemployment rate and high employment, with an ample

supply of good jobs; (c) price-level stability (or low inflation).

6. Today, there are numerous instruments through which the government can

steer the economy: (a) Fiscal policy (government spending and taxation) helps

determine the allocation of resources between private and collective goods, affects

people income and consumption, and provides incentives for investment and other

economic decisions. (b) Monetary policy (particularly central-bank regulation of the

money supply to influence interest rates and credit conditions) affects sectors in

the economy that are interest-sensitive.

7. The easiest case, in macroeconomic equilibrium, is the one assumed by

classical economists: a quick clearing of all markets and perfect foresight. In that

case, monetary policy is neutral in the sense that it cannot affect the real wage,

employment, or output, neither in the short run nor in the long run. A doubling of

the money supply simply leads to a doubling of the aggregate price level. A fiscal

expansion is fully crowded out by a fall in private investment (and net exports) on

account of a rise in the interest rate (and an appreciation of the currency), so that

neither employment nor output is affected. Hence, only supply-side policies, such

as changes in the capital stock or in the various tax rates, can affect employment

and output.

8. Modern day versions of the classical economists are the new classical, also

called the "fresh water" economists, who stress rational expectations in stochastic

environments and microeconomic foundations of macroeconomic relationships.

Lecture Note for Accounting Students 67

9. A related breed of macroeconomists are the supply siders who believe in

cutting taxes as this would boost tax revenue and alleviate the need to cut public

spending. The supply siders were very influential in the 1980s, but have largely

been discredited.

10. The older variety of Keynesian economists assumed sticky prices in the short

run, so that employment and output were mainly determined by aggregate

demand in the short run. A recent school of new Keynesians give the

microeconomic underpinnings by stressing imperfect competition, coordination

failures, and credit restrictions.

11. The neo-Keynesian synthesis allows for a Keynesian short run and classical

long run by introducing the assumption of adaptive expectations regarding the

price level. In the short run the multiplier associated with a fiscal expansion is

further reduced due to the rise in the price level. This leads to a contraction in real

money balances, a further rise in the interest rate, and thus a dampening of the

expansion in aggregate demand. Over time households revise their expectations

upwards. As a result, aggregate supply and employment fall until the original

equilibrium is restored again. The long-run output and employment multipliers for

a rise in government spending are thus zero because any expansion of aggregate

demand is fully offset by reductions in private investment (and net exports) caused

by a higher interest rate (and appreciation of the currency).

12. Monetarists are somewhere in between the classical and Keynesian

economists. They allow for adaptive expectations, but believe in the ineffectiveness

of fiscal policy and the potential harmfulness of using monetary policy to manage

aggregate demand. Monetarists believe in long and variable lags in monetary policy

and therefore advocate a constant and modest rate of monetary growth. Clearly,

monetarists are also deeply suspicious of using fiscal policy to fight unemployment.

Lecture Note for Accounting Students 68

FURTHER READING:

 Ben [Link], & Frederick van der Ploeg (2002) Foundation of Modern

Macroeconomics, Oxford University Press, New York.

 Henock Adamu (2013) Principles of Economics: Introductory Theories,

printed by Far East Trading, Addis Ababa, Ethiopia.

 Mankiw, N.G. (2007) Macroeconomics, 4th edn,

 Saumuelson, P.A, (2006) Economics, 18th edn., Tata McGraw-Hill

Publishing Company Limited, New Delhi.

Lecture Note for Accounting Students 69