2.

1 Approaches of Measuring GDP

2.2 Other Social Accounts (GNP, NNP, NI, PI and DI)
2.3 Nominal versus Real GDP
2.4 GDP and Welfare
2.5 The GDP Deflator & the Consumer Price Index
2.6 The Business Cycle
2.7 Unemployment and Inflation
Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 1
 National Income accounting refers to a set of rules and
techniques that are used to measure the national income of
a country.

 National income is a measure of the value of goods and

services produced by the residents of an economy in a
given period of time, usually a year.

 National income accounting is a government bookkeeping

system that measures a country's economic activity—
offering insight into how an economy is performing.

Compiled by Tesfaye E.,;WU; department of

11/24/2014 economics 2
• National Income Accounting (NIA) is an accounting
record of the level of economic activities of an
economy as a whole.
• It is a measure of an aggregate output, income and
expenditure in an economy.
 National income in many countries is either
represented by Gross Domestic Product (GDP) or
Gross National Product (GNP).
 National income acco unting system s allow
countries to assess the current standard of living or
the distribution of income within a population, as
well as assess the effects of various economic
policies.

Compiled by Tesfaye E.,;WU; department of

11/24/2014 economics 3
v Indicates of economic growth:
 It indicates performance and the level of economic
growth in an economy. The data on national income
and per capita display the true picture of the health of
an economy. It both are increasing continuously. It
surely reflects an increase in economic welfare,
otherwise not
v Helps in policy formulation
 Statistical data on national income not only helps in
making economic analysis but also helps in policy
f o r m u l a t i o n . M o re o ve r i t i n t o o n l y h e l p s i n
formulating fiscal policy, monetary policy, foreign trade
policy but also helps in making modifications and
amendments wherever necessary.
Compiled by Tesfaye E.,;WU; department of
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v Helpful in making comparison:
§ It helps us in comparing national income and per capital
income of our country with those of other countries. This
may leads us to make suitable changes in our plans and
approach to achieve rapid economic development of our
country.
v Helpful to trade unions:
 National accounts throw light on distribution of factor
income which is very helpful to trade unions and other
labour organizations in making rational analysis of the
remuneration the labourers are getting.
v Distribution of income:
 National income accounting describes distribution of
national income in terms of factors like interest, rent, profit
& wages.
 It also shows the relative significance of the factors of
production in the economy. 11/24/2014 Compiled
economics
by Tesfaye E.,;WU; department of
5
v Helpful in economic planning:
National income accounting is helpful in economic
planning. The planning commission comes to know
about the resources available for economic planning.
v Structural changes in the economy:
NIA is helpful in providing knowledge of structural
changes in the economy. We are able to know that
decrease or increase in share of agriculture and
industry in national income. It helps to know the
sectorial contributions.
v Facilitate forecasting:
NIA is helpful in forecasting the effect of economic
policies on the level of production and employment.
Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 6
 In sum up: National income accounting:
 Designed to measure the overall production performance
of the economy;
 show the long-run course that the economy has been
following;
 provide basis for formulation & application of public
policies.

 The best available indicator of economy’s wellbeing

is its total output of goods & services or aggregate
output.
 Two basic social accounting measures of the total output of
goods & services are GDP & GNP.
Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 7
 GDP is the total monetary value of all final goods & services
produced within the territories of the economy in a given year.
 It is the monetary values of output produced using all the
factors of production located in the territory of a country
whether owned by foreigners or domestic citizens. It is
territorial.
 GNP is the total monetary value of all final goods & services
produced by factors of production owned by citizens of the
country in a given year, regardless of were is produced. Output
can be produced either inside or outside the boundary of the
country. It is citizenship.
 Thus, GDP & GNP are related as follows:
GNP = GDP + Net Factor Income (NFI)
 NFI = Factor income earned by citizens (all resources) from
abroad minus factor income earned by foreign resources.

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11/24/2014 economics 8
 GDP is more commonly taken as the basic
measure of a nation’s output as compared
to [Link] 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.

Compiled by Tesfaye E.,;WU; department of

11/24/2014 economics 9
What are included:
All the currently produced goods and services which has
market prices:
Ø Final goods and services with having market price
Ø Intermediate goods that have not yet been used in final
goods and services.
Ø Raw materials that have been produced, but not yet used
in the production of intermediate or final goods.

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11/24/2014 economics 10
1) What should be excluded:-
 NIAs ignore:
1. Transactions involving intermediate goods (in order to avoid
double counting).
2. Non-productive transactions: purely financial transactions (public
& private transfer payments, and buying & selling of securities) as
recipients make no contribution to current production in return.
3. Second-hand sales as such sales either do not reflect current
production or involve double counting. Sales of used goods not be
included in order to avoid double counting problems.
4. Exclusion of non-market products/Non-market activities: there
are various types of output produced, with have no estimated market
values, such as home activities, child care, etc.
5. Illegal goods: all the black market economic activities are not
included due to its difficulty of information.
6. Intermediate goods that are used to produce other final goods.
7. Non-domestic product: Sales of goods that were produced
outside our borders should be excluded from GDP
calculation. Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 11
There are three different methods to measure
[Link] are:
1. The output approach
2. The expenditure approach and
3. The income approach.
Ø In the absence of any measurement errors, the three
approaches will deliver exactly the same result. Each
approach is simply constitutes a different way of
looking at the same thing.
Ø All three methods for measuring GDP give equal
results because the aggregate spending on
goods and services is the income to the firms.
And every final good or service produced is a part of
aggregate spending either through consumption or
investment by firms.
Compiled by Tesfaye E.,;WU; department of
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 The GDP, which is the total value added of products, should
match the income received by the firms from the production of
those products. The flow of funds received by the firms is
distributed in wages, rent, profit, interest repayments
etc.
 The goods and services produced are either consumed or used
as inventories. Consumed goods add to consumer spending, and
inventories are the firms' spending (investment on the products).
Thus, the aggregate spending is equal to the total value of final
goods and services.

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• In output approach, GDP can be measured either using final
values output or value added in each stage of
production.
 GDP is the sum of the market value of final goods &
services or the sum of the value added at each stage of
production.
Stages of Production Sales Value Value Added
(Birr) (Birr)
Firm A, sheep ranch 60 60
Firm B, Wool processor 100 40
Firm C, suit manufacturer 125 25
Firm D, clothing wholesaler 175 50
Firm E, clothing retailer(final values of 250 75
sheep ranch)
Total sales value 710
Total Value added 250
Compiled by Tesfaye E.,;WU; department of
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 The value added approach measures economic
activity by adding the market value of goods and
services produced. It excludes the value of any goods
and services used up in intermediate stages of
production.
 The approach makes use of the concept of value-
added. The value added for any producer is the
difference between the value of output and the value
of inputs it purchased from other producers.
 Value added is computed by taking the difference
between the value of gross output of all goods and
services produced in a given period and the value of
all intermediate inputs used in the production
process at each stage during theCompiled
same
11/24/2014 economics
period.
by Tesfaye E.,;WU; department of
15
 Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 16
• All final goods & services produced in an
economy are purchased either by three
domestic sectors: households, government
& business firms; or by foreign nations.
GDP = C + I + G + NX
? ? ? ?
 Is all that is produced sold?
 Changes in Inventories!
 This approach includes expenditures on goods and
services to satisfy the needs of final buyers.
 The expenditure on intermediate goods and services;
resale of consumer and capital goods are excluded from
being calculated in GDP measure.
Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 17
 The national income accounts divide GDP into four
broad categories of spending:
Ø Consumption (C)
Ø Investment (I)
Ø Government purchases (G)
Ø Net exports (NX).
 Thus, letting Y stand for GDP,
 Y = C + I + G + NX.
 G D P i s t h e s u m o f c o n s u m p t i o n , i n ve s t m e n t ,
government purchases, and net exports. Each dollar of
GDP falls into one of these categories.
 This equation is an identity: an equation that must hold
because of the way the variables are defined.
 It is called the national income accounts identity.
Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 18
 Consumption consists of the goods and services
bought by households. It is divided into three
subcategories:
1. Nondurable goods,
2. Durable goods,
3. And services.
 Nondurable goods are goods that last only a short
time, such as food and clothing.
 Durable goods are goods that last a long time, such
as cars and TVs.
 Services include the work done for consumers by
individuals and firms, such as haircuts and doctor
visits.
Compiled by Tesfaye E.,;WU; department of
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 Investment consists of goods bought for
future use. Investment is also divided into three
subcategories:
1. Business fixed investment,
2. Residential fixed investment, and
3. Inventory investment.
 Business fixed investment is the purchase of
new plant and equipment by firms.
 Residential investment is the purchase of new
housing by households and landlords.
 Inventory investment is the increase in firms’
inventories of goods (if inventories are falling,
inventory investment is negative). Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 20
 Government purchases are the goods and
services bought by federal, state, and local
governments.
 This category includes such items as military
equipment, highways, and the services that
government workers provide.
 It does not include transfer payments to
individuals, such as Social Security and
welfare.
 Because transfer payments reallocate existing
income and are not made in exchange for
goods and services, they are not part of GDP.
Compiled by Tesfaye E.,;WU; department of
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 Net exports: takes into account trade with other countries.
 Net exports are the value of goods and services exported to
other countries minus the value of goods and services that
foreigners provide us.
 Net exports represent the net expenditure from abroad on
our goods and services, which provides income for domestic
producers.
 In contrast to the income approach, the expenditure
approach focuses on the uses of GDP across various
expenditure categories.
 The expenditure C , G and I consists of expenditure on
imported goods which are not part of Ethiopian GDP.
 Foreign countries also spend on our export, which is not
part of their output. Thus, X-M should be considered in
oredr to get the net spending by a nation.
Compiled by Tesfaye E.,;WU; department of
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 The Income Approach
 As the name suggests, the income approach calculates the GDP by
summing up the income earned by domestic factors of production
annually.
 GDP can also be determined by summing up incomes
derived from the production of total output.
 GDP is the sum of all incomes earned by all factors of
production which contribute to production plus 2 non-
factor payments.
 Therefore, GDP is the sum of the following items.
1. Compensation of employees (W, S): this is the income from sales
of labor services during a given year. It incorporates wages,
salaries, and fringe benefits such as employers provided insurance
and employers contribution to pension funds.
2. Rental incomes (R): is earned by those who supply the services
of land, mineral rights, and building for use by others.
3. Interest (I): includes interest payments individuals receive on
saving, certificate deposit and corporate bonds.
Compiled by Tesfaye E.,;WU; department of
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4. Proprietor’s income (∏p): is net income of sole
proprietorships and partners.
5. Corporate profit (∏c): includes dividends,
undistributed profits, and corporate profits taxes.
6. Indirect business taxes (IBT): taxes imposed on
sales final products by business firms that
increases the cost of these firms and are
therefore, reflected in the market value of goods
and services sold. Example: sales tax, excise tax,
business property tax, license fee.
7. Capital consumption allowance (D): depreciation of
capital assets.
 Then the gross domestic product/income (GDP) is
defined as:
 GDP = (W+S) + R + I + ∏ + D + IBT, where ∏ = ∏p
+ ∏c
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 The national income accounts include other measures of income that differ slightly
in definition from GDP.
 To see how the alternative measures of income relate to one another, we start
with GDP and add or subtract various quantities. 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.
Whereas GDP measures the total income produced domestically, GNP measures
the total income earned by citizens of a nation.
 For instance, if a Japanese resident owns an apartment building in Ethiopia, the
rental income he earns is part of Ethiopian GDP because it is earned in Ethiopia.
 But because this rental income is a factor payment to abroad, it is not part of
Ethiopian GNP.
 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.

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11/24/2014 economics 25
 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.
 The next adjustment in the national income accounts
is for indirect business taxes, such as sales taxes.
 These taxes, which make up about 10 percent of NNP,
place a wedge between the price that consumers pay
for a good and the price that firms receive.
 Because firms never receive this tax wedge, 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.
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 National income measures how much everyone in the
economy has earned.
 The national income accounts divide national income into
five components, depending on the way the income is
earned. The five categories, of national income paid in each
category, are
 Compensation of employees: the wages and fringe
benefits earned by workers.
 Proprietors’ income: the income of non corporate
businesses, such as small farms, and law partnerships.
 Rental income: the income that landlords receive,
including the imputed rent that homeowners “pay’’ to
themselves, less expenses, such as depreciation.
 Corporate profits: the income of corporations after
payments to their workers and creditors.
 Net interest: the interest domestic businesses pay minus
the interest they receive, plus interest earned from
foreigners. Compiled by Tesfaye E.,;WU; department of
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 A series of adjustments takes us from national
income to personal income, the amount of
income that households and non corporate
businesses receive.
 T h re e o f t h e s e a d j u s t m e n t s a re m o s t
important.
 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. Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 28
 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.
 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. (The difference
between personal interest and net interest arises in
part from the interest on the government debt.)
 Thus, personal income is:
Compiled by Tesfaye E.,;WU; department of
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 Personal Income = National Income
− Corporate Profits
− Social Insurance Contributions
− Net Interest
+ Dividends
+ Government Transfers to Individuals
+ Personal Interest Income.
 Following this, if we subtract personal tax payments and certain nontax
payments to the government (such as parking tickets), we obtain
disposable personal income:
 Disposable Personal Income = Personal Income – Personal Tax and
Nontax Payments.
 We are interested in disposable personal income because it is the
amount households and non corporate businesses have available
to spend after satisfying their tax obligations to the government.
Disposable personal income can be used either for Consumption
or saving.
 PDI = C + S
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GDP + NFI

= GNP –D

= NNP – IBT

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

11/24/2014 economics
= DI
Compiled by Tesfaye E.,;WU; department of
31
 Nominal GDP(NGDP): it is the monetary
/the market value of all final goods &
services produced at particular time valued
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.
Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 32
 To illustrate the difference between Nominal GDP and Real
GDP consider an economy producing only two goods: Teff
and Sugar.
 In this economy GDP is the sum of the values of all the Teff
produced and the values of all the sugar produced.
 That is:
 GDP = (Price of Teff X quantity of Teff produced per year) + (Price of
Sugar X quantity of Sugar produced per year).
 Apparently, GDP is a good way of measuring the average
dollar value of the goods produced in any year.
 Yet it is not a good way of measuring differences in the
average quantities of goods produced over time because
GDP can go up from year to year for two reasons: because
of price rises or because of quantity rises.

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11/24/2014 economics 33
 Thus, GDP computed by this method is not a
good measure of economic well being.
 This means, nominal GDP does not accurately
reflect how well the economy can satisfy the
demand of economic agents.
 If all prices doubles without any change in
quantities of goods and services produced,
GDP would double.
 At this junction, it would be misleading to say
that the economy’s ability to satisfy demands
has doubled, since quantities of everything
goods and ser vices produced remain
unchanged.
 Economists call the values of goods and
services measured at current prices nominal
GDP. 11/24/2014
Compiled by Tesfaye E.,;WU; department of
economics 34
 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.
 Real GDP, which is the value of all goods and services produced during
a year measured using a common set of prices. These prices are the
ones that prevailed in one year – called the base year

Year Quantity Price RGDP (in 2000

NGDP year)
1999 10 20,000 200,000 200,000
2000 12 20,000 240,000 240,000
2001 13 26,000 338,000 260,000
2002 13 30,000 390,000 260,000

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11/24/2014 economics 35
Year [Link] Price of No. of car Price per
computer computer produced unit of car
produced per unit
1990 500000 6000&$ 1000000 12000$
2000 5000000 2000$ 1500000 20000$

A. Compute nominal GDP for the year 1990 and 2000

B. Calculate real GDP in 1990 and 2000, using 1990 as the base year
C. Calculate the percentage change in real GDP between 1990 and
2000 using 1990 as the base year.
D. Calculate real GDP in 1990 and 2000, using 2000 as the base year.
E. Calculate the percentage change in real GDP between 1990 and
2000 using 2000 as the base year.
F. Explain why your answers to parts c and e are different. Do you
feel there is one that more accurately measures the true growth
in GDP? Which one, and why?

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11/24/2014 economics 36
 GDP has limitations in measuring the social
wellbeing of the people in a nation since:
 It excludes non-market transactions & thus
underestimates non-monetary economies.
 It does not include the underground economy
(black market) transactions.
 It ignores the quality of goods & services.
 It ignores cost of environmental damage, which
could decrease the quality of lives.
 It does not accounted for the satisfaction
obtained from recreational activities & other
uses of leisure time.
 It is based on estimations & thus may not
accurately reflect even the transactions it
explicitly intends to measure.

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11/24/2014 economics 37
The GDP deflator, also called the implicit
price deflator of GDP, is defined as follows:
Nominal GDP
GDP Deflator   100
Real GDP
NGDP = RGDP x GDP deflator (/100)

Measures Measures Measures the

the current the price of output
monetary economy’s relative to its
B B B
value of the output at
economy’s constant price in the base
output prices year
GDP deflator reflects what is happening to
the overall level of prices in the economy.
11/24/2014
Compiled by Tesfaye E.,;WU; department of
economics 38
 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 single index.

Cost of a Market Basket of Products at Current Prices

CPI   100
Cost of the Same Basket of Products at Base Year Prices

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

Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 39
 CPI & GDP deflator differ in 3 main ways:
1. 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. 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, but fixed in CPI. 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.
3. CPI directly includes prices of imports, whereas the GDP
deflator includes only prices of products produced domestically.
v Economists call a price index with a fixed basket of goods a
Laspeyres index and a price index with a changing basket a Paasche
Compiled by Tesfaye E.,;WU; department of
index. 11/24/2014 economics 40
 N e i the r o f the two i ndi ce s i s cl e ar ly
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.

Nominal GDP NGDP

Real GDP    100
CPI/100 CPI

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11/24/2014 economics 41
v Business cycle: the term used to describe fluctuations in
aggregate production as measured by the ups & downs in
RGDP.
v Business cycle is the recurrent ups and downs in the
levels of economic activities that extend over a period of
several years.
 It is the non-regular pattern of expansion & contraction in
economic activity around the path of trend growth.
 The is the path that 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.
Compiled by Tesfaye E.,;WU; department of
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 2. Second, factors are not fully employed all the time. Thus,
output can be increased by increasing capacity
utilization. Output is not always at its trend level, that is,
the level corresponding to full employment of the
factors of production. Rather output fluctuates around
Trend Level/
Output (Real GDP)

the trend level. Peak

Potential/
Con essio

Full-Emp’t
( Re

Output
trac n)
c

Actual
ti o n

(Rec sion
y)
Output

over
n
Expa
Trough

11/24/2014
Time
Compiled by Tesfaye E.,;WU; department of economics 43
 Inflation, growth, and unemployment are related through
the business cycle.

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11/24/2014 economics 44
 Business cycle is thus characterized by peaks, trough, periods of
contraction and expansion.
 Peak: this refers to the full employment level of an economy. Here the
national output is at or very closer to the capacity. There is shortage of
labor, parties and materials. National income corresponds to the high
degree of factor utilizations. It is highly characterized by the presence of
inflation.
 Recession (Contraction): unemployment increases and less output is
produced than can in fact be produced with the existing resources and
technology. Prices also decline as unemployment increases.
 Trough: refers to the period when output and employment become at
nadir level. At this point there is massive unemployment and idle
productive capacities. Most businesses are likely to fail as there is small
demand for their products.
 Recovery (expansion): the employment of factors of production
increased, and that is a source of increased production.

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11/24/2014 economics 45
Business cycle movements are

NB: is the trend growth rate constant: it

varies with changes in
.
Output gap: deviations of output from trend
(= Potential Output – Actual Output).
 Output gap grows during recessions, &
declines (& even becomes negative) during
expansions.
 A long expansion reduces unemp’t too
much, causes inflationar y pressures &
triggers policies to fight inflation – such
policies usually create recessions.
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 Unemployment occurs when someone is willing and
able to work but does not have a paid job or
engaged in self- employment.
 Unemployment, according to the OECD, is people above a
specified age not being in paid employment or self-
employment but currently available for work during the
reference period.
 A person is employed if he or she spent some of the
previous week working at a paid job, or engaged with self
employment.
 The labor force is defined as the sum of the employed
and unemployed, and the unemployment rate is defined as
the percentage of the labor force that is unemployed. That
is,
Ø ����� ����� = ������ �� �������� + Compiled
������ �� ����������.
by Tesfaye E.,;WU; department of
11/24/2014 economics 47
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 ofCompiled
labor by Tesfayeforce
E.,;WU; department of
11/24/2014 economics 48
• Different economists categorize unemployment in to
different groups. The most common form of
unemployment types are:
v Frictional unemployment: this is the most appearing
form of unemployment.
• At any point of time, some workers will be in the process
of voluntary switching jobs.
• Others will have jobs connection but will be temporally
laid off because of seasonality.
• Example: college graduates, agricultural workers during off
harvest time.
• It is resulting from people who have left jobs that didn’t
work out & are searching for new employment, or people
who are either entering or re-entering the LF to search for
a job.
• It result from occurrences in a
dynamic economy; and, often, one cannot be distinguished
from the other. Compiled by Tesfaye E.,;WU; department of
11/24/2014 economics 49
v Structural unemployment: this is a
type of unemployment emanating from
permanent shift in the pattern of demand
for goods and services or from change in
technology.
 Structurally unemployed people have skills
that are not in demand by employers due
to permanent change in technology of the
economy.
 It is resulting from permanent shifts in the pattern
of demand for goods & services or from changes
in technology such as automation.

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v Cyclical unemployment: results from the decline in real
GDP during period of economic down turn (recession) or in
any period when the economy fail to operate at its potential.
 It is resulting from dec lines in RGDP dur ing
recessions, or whenever the economy fails to operate
at its potential.
 It is the result of imbalances b/n aggregate purchases
& aggregate production at full-emp’t.
 It 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.

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 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.

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 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
l ayo f f s - t e m p o r a r y s u s p e n s i o n s o f
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.
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Costs of Unemp’t:
Unemp’t is of great concern because it has
[Link] 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
Compiled
11/24/2014 economics
revenue.
by Tesfaye E.,;WU; department of
54
 What relationship should we expect to find
between unemployment and real GDP?
B e c a u s e e m p l oye d wo r ke r s h e l p t o
produce goods and ser vices and
unemployed workers do not, increases in
the unemployment rate should be
associated with decreases in real GDP.
 T h i s n e g a t i ve re l a t i o n s h i p b e t we e n
unemployment and GDP is called Okun’s
law, after Arthur Okun, the economist who
first studied it
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 Inflation is a rise in the general price level.
 The inflation rate measures how fast prices are rising.
 A dollar today doesn’t buy as much as it did 20 years ago
 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 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
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 Inflation rate= (154.8-146)/146=0.06027
=6%
 Demand-pull inflation: Excess of total demand
contributes to the rise in general prices level. Firms and
business sector cannot, at least in the short run, respond
to these excess demand by expanding real output for the
obvious reason that all factors of productions are already
at full employment. As a result, the excess demand bids
up the price of the fixed output, causing demand-pull
inflation.
 Cost push inflation: is the inflation emanating from the
supply side or cost side of the market. Unions developed
to a considerable degree of strength and have control
over the wage rates. They obtain increased wage. On the
other side cost of productive factors imported may also
rise. As a result of an increased cost of production large
corporation pushes the increased cost of production on
to consumer by raising the prices of their production.
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 Structural inflation: is due to change in the structure of
total demand. This is due to the market power of big
business and unions. Prices and wages tend to be flexible
up ward but inflexible downward.

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The Philips Curve
The Phillips curve describes an empirical
relationship b/n inflation & unemp’t.
The curve suggests a trade-off between
inflation & unemp’t.
The Phillips Curve
Inflation Rate

0
Unemployment Rate

This trade-off should always be taken into

account when governments try to increase
output & emp’t or reduce inflation. 11/24/2014
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economics 59
This trade-off between unemp’t & inflation
holds in the short run. (However, there are
disagreements among economists.)
In the long run, there is no trade-off worth
speaking about b/n inflation & unemp’t.
I n t h e l o n g r u n , u n e m p ’ t r a t e i s
independent of inflation rate – the long
run Philips Curve is vertical at the natural
rate of unemp’t.

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