CHAPTER TWO

NATIONAL INCOME
ACCOUNTING
2.1. Definitions of National income Accounting

 National Income Accounting refers to the process of

record keeping for the overall economic activities of a
given country.

 National Income Accounting is measuring the value of

economic activity such as GDP and /or GNP.

 National Income Accounting is a set of rules and

definitions for measuring economic activity in the
aggregate economy.
 Cont..

It includes all goods and services produced in a

country in (part of) a fiscal year.
It is a way of measuring total or aggregate
production.
 National income account is an accounting record
of the level of economic activities of an
economy.
 Whether economy of a country is growing or not is not known
unless we can measure the total value of goods and services
produced in the country for different years.
 Cont..

 National Income: is a measure of the money value of

goods and services that are produced in a country in one
year.

 National income is measure of aggregate output,

income and expenditure in an economy.

 The main measures of aggregate economic activity are

Gross Domestic Product (GDP) and Gross National
Product (GNP).
 Cont..
 The importance of national income accounting:
1. Provides a measure of aggregate output and
income of an economy and explains the causes
for level of performance in the economy.
2. Enables us to observe the long-run course of the
economy and see whether it has grown, been
steady or stagnated.
3. Serves as a basic for the formulating and
applying public policies to improve the
performance of the economy.
 Cont...

o Gross Domestic Product is the Aggregate market value

of all final goods and services produced in a domestic

economy in a one-year period. i.e. whether by the
Ethiopians or foreign supplied resources.

o GDP is a measure of all currently produced final goods

and services evaluated at market prices.

oThe rate of economic growth is measured by GDP

 Cont...

 GDP calculates the value of final goods and

services produced within a geographic boundary
regardless of the nationality of the individual or
firm.

 Example, Foreign capital and labor used in

Ethiopia produce output and income are
included into Ethiopian GDP.
 Cont...

 Only the production of final goods and services

enter into GDP, the intermediate goods and
services do not enter into GDP.
 Such goods show up in GDP because they
contribute to the value of final goods in whose
production they are used.
 Cont..

 GDP is value of goods and services determined

by the common measuring of market prices.

 Does not exclude from GDP goods that are not

sold in markets;

 example, home production direct used to home

consumption without passing market process and
measured those goods by current prices.
 Con...

 But this does exclude from GDP goods that are

not sold in markets such as the non-reported
output from illegal activities such as:

 illegal drug sales,

 unreported sales,

 Prostitution, and other illegal activities.

In measuring GDP, we take the market values of goods

and services (GDP=

 Where: Pi = series of prices of outputs produced in

different sectors of an economy in certain period

 Qi = the quantity of various final goods and services

produced in an economy
 Con...

 Gross National Product is the Aggregate market value

of all final goods and services produced the citizens
and firms of a country in a one-year period.

 That is this measure includes only citizens and domestic

firms including the value of their production generated
outside of the country.

 Ethiopia capital and labor used abroad produce output

and income are included into Ethiopia GNP, not GDP.
GDP and GNP are related as follows:

GNP=GDP + NFI
NFI denotes Net Factor Income received from abroad which is

equal to factor income received from abroad by a country‘s

citizens less factor income paid for foreigners to abroad.
 If NFI >0, then GNP > GDP

 If NFI<0, then GNP < GDP

 If NFI =0, then GNP =GDP

2.2. The basic model: The circular flow diagram
 Circular-flow diagram: a visual model of the
economy that shows how dollars flow through markets
among households and firms.
 The circular-flow diagram offers a simple way of
organizing all the economic transactions that occur
between different sectors in the economy.
Accordingly, from the point of view of the number of
sectors involved in the analysis or in the model,
there are three major macroeconomic models:
a) Two sector model,
b) Three sector model (closed economy model) and
c) Four sector model (open economy model).
a) Two sector model
 This model represents the case where there are
only two sectors in the economy. (household
sector and the firm sector).
 Consumers or households either consume or save
their income.
Y = C + S,
Where, Y = income, C = Consumption expenditure, and
S = Saving
Since saving is used for investment or saving is by itself a form of
investment, S=I, the above equation can be rewritten:
 Y = C + I, Where, I = investment spending.
 Figure 2.1: Circular flow of income and spending in two sector mod

The inner loop shows the flows of goods and services, and factors
of production.
The outer loop represents the corresponding monetary (Birr or
dollar) flows.
 Households sector is the owner of factors of production like
land, labour and capital.
 These factors of payments are exchanged in resource
market.
 The factors of production are used by the firms.
 The payments to the factors of production are the income
(Y) from firms in the form of wage for labour or in the
form of rent for land or interest in the form of capital.

17
  These factors of production spend part of their income on
consumption goods (C) produced by firms and save (S) the
rest.
 Business sectors (firm) produce the outputs to be sold in
product market.
 These outputs are consumed by the households by spending
their income.
 Business sector receives revenue from the consumption.

18
 b) Three sector model (closed economy model)
 Household, firms and government are the three
parties involved in the economy.
 The model is also known as closed economy
model because it does not include trade with other
countries.
Y=C+S+G
Y = C + I + G, Where, G = Government
spending/ expenditure
 Cont..
HHs receive income from gov’t transfer
payments and pay tax to the gov’t.

Business firms also sell their goods and services

to the gov’t and pay tax
 Government sector on their part use the tax
income to finance its expenditure.
Figure 2.2: Circular flow of income and spending in three sector
model
 C) Four sector model (open economy model)
In addition to the three sector model, this model
includes the elements of trade such as import
and export are incorporated in the model.
Y = C + I + G + NX
Where: NX= Net export (X – M), M= Import
value and X= export value.
The open economy model can also be
demonstrated by the use of circular flow of
income and expenditure.
Figure 2.3: Circular flow of income and spending in four sector
model
HHs can get imported products at the same time,
business sector can also exports to other
countries.

In this model the gov’t plays a crucial role in

regulating the foreign exchange market along
with its previous role of collecting taxes and
government spending.
Since almost all countries around the world have
government involvement in the economy and have
 2.3. National Income Accounts Measures
 National Income Accounting is about measuring
the value of economic activity such as GDP
and /or GNP.
 Measuring the health of the economy.
 It is government book keeping system that
measures a country's economic activity.
 NIA gives formal structure for macroeconomic
theory models.
 Cont..
 It also helps to learn about what is constituted in
national economy and their behaviors.
Therefore, GDP summarizes all economic
activity over a period of time in terms of a single
figure/number.
 Other National Income Accounts Measures
Apart from GDP and GNP, there are also other social accounts which

have equal importance in macroeconomic analysis.

These are:
 Net Domestic Product:

 Capital used in production process wears out, or depreciates while it is

being used to produce output.
 Net Domestic Product (NDP) takes depreciation into account in
measuring the national income.
 It is the difference between Gross Domestic Product and the capital
consumption allowance which is a measure of depreciation of capital
goods used in production (D). 27
 For instance, if the total output of a country (GDP) in a given
year is 100 million US dollar and the lost part of capital goods in
generating this national output is 9.5 million US dollar, then the
net domestic product (NDP) of the country in that particular year
is 90.5 million USD.
 NDP measures net amount of goods and services produced in a
country in a given period
 It is the value of production minus the amount of capital used up
in producing that output.
 In developed countries, depreciation is about 11% of GDP, so
NDP is about 89% of GDP.
 No such formal estimation of depreciation in less developed
countries due to lack of data. 28
 Net National product (NNP)
It is a more accurate measure of economy‘s annual output than gross
national product and it is given as:
Net National product =Gross National product – Capital
consumption allowance
 The only difference between the two is that NDP is calculated from
GDP whereas the NNP is calculated from the (GNP).
 NDP = GDP – D and NNP = GNP – D

29
 National income (NI or Y)

 National income is the income earned by economic

resource (input) suppliers for their contributions of land,
labour, capital and entrepreneurial ability, which are
involved in the given year‘s production activity.
 It is the difference between the net national product (NNP)
or the net domestic product (NDP) and Indirect Taxes (IT).
 National Income = Net National Product – Indirect
Business Tax or,
 NI or Y = NNP – IT or NI = NDP – IT
30
 Personal income (PI)
It is the net value of national income and different personal payments

and receipts.
 It refers to income earned by persons or households. Persons in the

economy may not earn all the income earned as national income.
 PI = NI – {(Social security payments + corporate income taxes +
retained earnings + related payments)}
+ {(transfer payments received + subsidies + net interest income +
related earnings)}
 Social security payments: collected from individuals to help the poor,
the disabled and the senior citizens of the country.
 Corporate income tax: collected from profit or revenue of corporate
31
 Retained earnings: part of income generated by corporate
organizations and kept in the organization for generation of more
profit or for strengthening the capacity of the organization or
company. Revenue or profit that is not disbursed/paid out to
members for personal uses.
 Transfer payments: amount of money people receive from their
relatives or friends for free.
 Subsidies: money or the equivalent amount of other goods and
services given by the government to individuals, companies or
organizations to help them.
 Interest Income: income received on the saved amount of
32
money in banks.
 Disposable income (Yd)
 It is the amount of income that is left for a person after payment
of any taxes and transfers.
 It is the amount that the person is free to spend on whatever
he/she likes or to save.
 Yd = PI – (direct or personal income taxes).
 However, sometimes all transfers and taxes are considered at the
same time.
 In that case, the disposable income is directly calculated from
national income (Y).
 Thus, Disposable income (Yd) = Y + Transfers – Taxes
33
 Yd = Y + TR – T
 In most macroeconomics texts the value of national
income ‘Y’ is represented by values of GDP to avoid
complexity in computation and no loss of much accuracy
because of the substitution.
 Example, Suppose that the GDP of a country is $100
billion.
 If total paid tax is $10 billion and net transfers received
are $5 billion, what is disposable income?
 Solution: Yd = GDP + TR – T = $100 billion + $5 billion
-$10 billion = $95 billion 34
Personal savings (S)
 Personal saving is the amount of disposable income that is
left over and above consumption expenditure.
 It is the difference between disposable income (Yd) and
consumption expenditure (C): S = Yd – C
Where, ‘C’ is consumption expenditure;
S is personal saving and
Yd is disposable income
 For example, from the above example of disposable income,
we can calculate the value of personal saving (S) as follows if
related personal consumption expenditure (C) is 65 billion
USD.
 S = Yd – C
35
 = $95 billion – $65 billion = $30 billion
 2.4. Approaches to National Income Accounting
 There are three major approaches to measure GDP or
GNP.
1) Value Added (Product) Approach
2) Expenditure Approach
3) Income Approach
2.4.1. The Value Added (Product) Approach
According to this approach, total output of a country, is
obtained by adding the new values of goods and services
created at different stages of process or in different
sectors.
Only the value added at each stage of process in different
sectors is recorded.
 Value added is the increase in value that a firm
contributes to a product or service.
 Table, Computing value added in production
Stages of production Total value of Value
the quintal added(in
wheat at each birr)
stage(in birr)

Wheat at farm 200 200

Wheat in the market including 250 50
transportation

Wheat flour in the market 310 60

Bread in the market 460 150
Sandwich at cafeteria 530 70
Value added(Total income) 530
 Example of GDP throughCont..
value added Approach

Type of sectors(Industry) Value added in(Billions)

Agro foresters fisheries 1000
Mining 1500
Construction 1500
Manufacturing 4000
Transportation & utilities 3500
Whole sale and Retail trade 5000
Other service 3000
Gov’t enterprises 2500
Other enterprises 3000
GDP 25,000
 Cont..

 From the above table, the different value additions

from the different sectors of the economies are
added up to give the total GDP using value added
approach.
 Calculating GDP is to add up the value of all the
final goods and services produced in the
economy.
 2.4.2. Income Approach
In this approach, GDP is calculated by adding all the incomes

accruing to all factors of production used in producing the

national output.

 This approach focuses on aggregating the payments made

by firms to households, called factor payments
 This approach add up the income i.e. wages, rents,
interest, and profits- received by all factors of production
in producing final goods.
 Cont..
 When we use the income approach to measure GDP or GNP, we
add up all the incomes earned by different factors of
production: land, labour, capital and so on.
 Thus, the national income identity is given by the following
relation.
GDP = Y = W + R + I + Π + IT – D.
• Where, GNP = Y = Gross national product,
W = Wages of all workers (compensations of employees)
R = Rents paid to property owners (reward for services),
I= Interest on borrowed capitals
Π = Profit of business organizations,
IT = Indirect business taxes
D = Depreciation (Capital consumption allowance)
 Cont..
 Example: GDP by income approach
 Con…
 Compensation of employees: it includes wages
and salaries paid to households by firms and by
government.
 Proprietor’s income: is the income of sole
proprietorship, partnerships and cooperatives
business.
 Corporate profits : are the income of corporate
businesses.
 Con…
 Net interest: is the interest paid by business.
 Rental income: is the income received by property
owners in the form of rent.
 Depreciation: when capital assets wear out or become
obsolete, they decrease in value.
Indirect Taxes: Taxes like sales taxes, custom duties, and
license fees are included in indirect taxes.
These taxes are counted on the expenditure side, they must
also be counted on the income side.
 2.4.3. Expenditure approach
Here GDP is measured by adding all expenditures on final

goods and services produced in the country by all sectors of

the economy.
 Add up the total amount spent on all final goods during a
given period.
 The underlying assumption of using expenditure in measuring
income is that the expenditure of one sector or person is the
income of the other (receivers of that money spent by
other sectors).
 Cont..

 There are four economic agents i.e HHs, firms, the

government, and the rest of the world.
 These components are Consumption, Investment,
Government Purchases and Net Exports. Y = C + I + G +
NX
There are also four main categories of expenditure
Personal consumption expenditures(C): accounts for the largest
portion of GDP.
It consists of the goods and services bought by households.
It is divided into three subcategories:
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,
furniture, and TVs
Services include the work done for consumers by individuals
and firms, such as haircuts and doctor visits.
 Cont..
 Gross private domestic investment(I): includes
expenditure on raw materials (factors of production)
and final goods such as capital investments to generate
more output.
 This includes land, labour, machineries, buildings,
inventories of unsold goods (for merchants) and so
on.
 Investment is divided into three subcategories:
business fixed investment, residential fixed
investment, and inventory investment.
 Con…
 Government expenditure (G) is the goods

and services bought by federal, state, and local

governments.
 It represents all expenditure on goods and
services by government on behalf of the nation.
This category includes such items as military
equipment, highways, and the services that
government workers provide.
 Cont..
 Net exports (NX) are the value of goods and services
exported to other countries minus the value of goods
and services that foreigners provide us.
Exports (X) represents foreign expenditure on our goods
and services which should be added on our national
income while
imports (M) represent our expenses on foreign goods and
services which overstate our output to
be deducted from the national income.
 GDP = Y= C + I + G + X – M = C + I + G + NX
 Con…
Example: GDP by Expenditure approach
 2.5. Limitations of GDP
 The figure of GDP or GNP does not tell us the long term
sustainability of gains from production.
 The values of GDP and/or GNP do not indicate
composition of national outputs
GDP ignores the quality aspect of goods and services.
Measurement errors on illegal drug sales, under-the-
counter sales of goods to avoid income and sales taxes
 Cont..
 Relative improvement in quality of some items and
relative growth in some sectors is not known from the
value of GDP or GNP.
 Income distribution is not known from the figure of GDP
or GNP.
 GDP or GNP ignores underground economy (black
market) transaction.
 The underground economy is the part of the economy
that people hide from the government either because
 2.6. Nominal GDP vs Real GDP

1. Nominal GDP is the value of all final goods and

services based on the prices existing during the time
period of production. It is the value of all final
goods and services valued at current year price.
Nominal GDP can grow in three ways:
 When output rises and prices remain constant.
 Prices rise and output remains unchanged.
 When both prices and output rise
Hence, GDP that is not adjusted for inflation is called

Nominal GDP.
 Cont..

 The problem is how to adjust GDP to reflect only changes in

output and not changes in prices.
 This adjustment helps us in comparing the GDP over time
when prices are changing.
 In order to know this we must understand the meaning of real
GDP.
 Cont..
2. Real GDP is the value of all final goods produced during a given
time period based on the prices existing in a selected base year.
It is the value of all final goods and services valued at base
year price (constant price).
 It is also known as GDP in constant price ,GDP adjusted for
inflation.
 The base year may change from time to time-a given base year price may be
used for five or more years.
 To get the most appropriate measure of national economic
performances, nominal GDP should be adjusted to the real GDP by
deflating NGDP when price is rising and by inflating it when price
is falling.
 2.7. GDP deflator and inflation rate

The GDP Deflator: The calculation of real GDP gives us a

useful measure of inflation known as the GDP deflator.
It reflects what‘s happening to the overall level of prices in

the economy.
 GDP deflator is the ratio of nominal GDP to real GDP.

 GDP deflator =

The GDP deflator is an index measure of change in the

general price level.
 Example: Given the data (Table 2.1) on total output (goods and
services) and price level (average price) in respective years, we
can calculate nominal GDP, real GDP and GDP deflator.
 Assume that all goods and services are measurable in similar
units for the sake of simplicity.
 Let us take year 1970 as the base year and assume that the base
year is changed to the year 1990.
 From the table, in the selected base year both nominal GDP
and real GDP are equal.
 Nominal GDP may change because of change in price level even
if no change in fiscal output.
58
 However, real GDP remains unchanged if there is no
change in physical output.
 For instance, compare both values of real GDP and
nominal GDP of the years 1980 and 1985.
 Since no change in physical output (15 units in both
years), no change in real GDP too, which remains 30
million Birr in both years.

59
Table 2.1: Real GDP and nominal GDP
Year Unit of goods Price Nominal GDP Real GDP GDP
and services level (NGDP) (RGDP) deflator
(in millions) (in million (in million (NGDP/
Birr) Birr) RGDP)
1970 10 2 20 20 1
1975 12 3 36 24 1.5
1980 15 4 60 30 2
1985 15 6 90 30 3
1988 20 7 140 40 3.5
1990 25 8 200 200 1
1994 30 10 300 240 1.25
1996 30 11 330 240 1.375
1998 32 15 480 256 1.875
1999 34 18 612 272 2.25
2000 35 20 700 280 2.5
60