MACROECONOMICS

CHAPTER TWO

NATIONAL INCOME
ACCOUNTING

11/30/2025 1
Introduction
National Income Accounting (NIA) is an accounting
record of the level of economic activity of an economy.
It is a measure of an aggregate output, income and
expenditure in an economy.
It provides a comprehensive framework for collecting and
organizing macroeconomic data, allowing economists and
policymakers to monitor the performance of the economy
over a specific period, typically a year or a quarter.

2
Introduction….
To have an idea of the performance of the economy,
measuring the national income of a country is extremely
important.
But measuring national income is an extremely
complicated large task.
However, economists have devised various ways of
estimating national income.
In this chapter, we will discuss about different methods
of measuring national income of an economy.
3
What is National Income?
 The national income of a country is the value, expressed in
monetary terms of the net contribution of the FOP through
the production units in the country and abroad in the year.
 It is the monetary expression of the current
flow of net final goods and services resulting
from the production activities of the national
residents of a country during the year.
It is the net domestic product (net domestic
income) of a country plus net income from
abroad. 4
What is National Income?.......
If all the NI is consumed then the NI consists of
consumer’s goods and services only.
If only a part of the NI is consumed in the
year then the part that remains accumulate
as a stock of goods or as capital stocks.
Thus, NI is the goods and services available
to the normal residents in a country to
consume or to invest as a result of their
production efforts in the year.
5
What is National Income?.......
To wrap up, NI is the aggregate factor income (i.e.,
earning of labor and capital, etc.), which arises from the
current production of goods and services by the nation’s
economy.
The nation’s economy refers to the FOP (labor and
capital, etc.) supplied by the normal residents of the
national territory.
Based on the above definition NI can be interpreted in
three ways.
6
What is National Income?.......
NI represents a receipt total,
NI represents an expenditure total, and
NI represents a total value of current production.
 It can also points to note from NI Definition

NI refers to the income of a country, say, Ethiopia.

It measures refers to a specified period of time, say, a
year.
NI includes all types of G&S, which have an exchange
value, counting each one of them only once. 7
What is National Income?.......
To avoid double or multiple counting in the calculation
of NI, there are two statistical methods.
I. Final products method
We add up the value of final products only.
We first take the total value of the final consumer goods
and producer goods produced in the country during the
year.
Add up collective gov’t goods and services to get
aggregate of all final gas produced during the year.
8
What is National Income?.......
II. Value-added method

We add the values created at each stage in the

manufacturing of a commodity.
Then all such values accruing at all processes in
the manufacturing of all commodities are added up
together to arrive at the national income of the country.
Example: Let us suppose that a ready-made bush-shirt
passes through four Stages of production.
• In this case, we should take only the value of bush-shirt
after stage four of production.
9
What is National Income?.......
Factors Determining National Income
Quality and quantity of factor of production: quality &
quantity of labor & capital matters on output.
The state of technical know-how: practical knowledge &
ability to perform tasks for better use resources. It needs
to go beyond theoretical knowledge for achieving high
quality goods.
Political stability: if there is political turmoil, it is
difficult to maintain production at highest level.
10
What is National Income Accounting?
 It is an accounting record of the level of economic
activities of an economy.
The instruments that help us to measure the national
income of the country.
The various types of national income accounts helps us to
measure the level of production in the economy at some
point of time, and explain the immediate causes of the
level of performance.

11
What is National Income Accounting?
 There are various types of total related to NIA. These
are:-
▫ Gross national product (GNP)
▫ Gross domestic product (GDP)
▫ Net national product (NNP)
▫ National income (NI) or net national income at factor cost
▫ Personal income (PI)
▫ Disposable personal income (DPI); and Real income (RI)

12
2.1. Basic Concepts of GDP and GNP
I. Gross Domestic Product (GDP):
 It is the value of all final goods and services produced
with in the territorial boundary of an economy in a
given time period.
NB: GDP is a flow not a stock concept.
It is an attempt to summarize all economic
activity over a period of time in terms of a
single number.
It is most important measure of overall
13
2.1. Basic Concepts of GDP and
GNP…….
II. Gross National Product (GNP):
 It is the money value of the total national production
for any given period as well as the value earned by its
citizens from abroad.
 It is the nation’s total production of G & S evaluated in
terms of the market prices of G & S produced usually in a
year.
 It includes all the economic productions in the economy
during one year.
14
2.1. Basic Concepts of GDP and
GNP…….
GDP vs. GNP
 GNP is the value of final G & S produced by domestically
owned FOP while GDP is the value of final G & S produced within
the country’s territory within a given period, the FOP used might
not be domestically owned.
 A country's GDP measures the strength of its local economy
whereas the GNP measures the overall economic strength of a
country.
 GDP is territorial while GNP is national.

𝐺𝑁𝑃 =𝐺𝐷𝑃 + 𝑁𝐹𝐼

15
2.2. Approaches of Measuring National Income (GDP/GNP)

There are three methods of estimating the national income

of a country.
In principle, all the methods lead to the same results.
The three methods are:

A. Expenditure approach,
B. Income approach and
C. Value-Added Approach.

16
2.2. Approaches of Measuring National Income (GDP/GNP)….

I. Expenditure Approach
 The GDP can be viewed as the nation’s total expenditure
on G & S produced during the year.
 Under the expenditure approach to GDP,
the total national expenditure can be
broken down in to the following
categories:
 Personal consumption expenditure (C)
 Gross domestic private investment (I)
17
2.2. Approaches of Measuring National Income (GDP/GNP)….

I. Expenditure Approach…..
a) Personal consumption expenditure: It includes the
consumption expenditure made for both durable goods
(such as, motor-cars, radio-sets, etc., but not houses) and
non-durable goods (such as, food, drinks, clothing, etc.)
produced in the country during the year.
 This sub-head also includes expenditure on the purchase
of a house but it should be treated as investment rather
than consumption expenditure.
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2.2. Approaches of Measuring National Income (GDP/GNP)….

I. Expenditure Approach…..
b) Gross Domestic Private Investment (I): It is the total
spending of private businesses and households on new
capitals and new residential constructions.
 This item includes private investment in ‘capital’ or
‘producer goods’, such as, buildings, machinery, plant,
equipment, etc.
 Business firms primarily purchase such goods.

19
2.2. Approaches of Measuring National Income (GDP/GNP)….

I. Expenditure Approach…..
c) Gov’ts’ Purchases of G&S (G): The governments (central,
state and local) purchase from the market: consumer goods,
such as, paper, stationery, cloth, etc., as well as investment
goods, such as machinery, equipment, plant, etc., for
their own enterprises.
 In addition, the governments also purchase a number of
different services such as military, police, secretarial, etc.
 Transfer payments should be excluded.

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2.2. Approaches of Measuring National Income (GDP/GNP)….

I. Expenditure Approach…..
d) Net Export /Net Foreign Demand (): Net exports represent the
net expenditure from abroad on our goods and services, which
provides income for domestic producers.
 The entire production of a country is not sold within the country
because some products export.
 At the same time, the country imports some finished goods
from other countries during the year.
 To make proper allowance for such exports and imports, the
value of imports should be deducted from the value of exports.
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2.2. Approaches of Measuring National Income (GDP/GNP)….

I. Expenditure Approach…..
 Therefore, if the entire production of a country is purchased at
market prices, the amount spent will represent the GDP of the
country at market price.
 Finally, to estimate the GDP, we should add all the above
categories of expenditure.
 Or

Where IR is income received

IP is income paid
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2.2. Approaches of Measuring National Income (GDP/GNP)….

II. Income Approach

 It is a method to measure a nation’s economic output by
adding up the income generated from the production of
G&S.
 The expenditure incurred on purchasing goods and
services produced in a country during the year also
becomes the income of the various factors, which
collaborated in the production of those goods and
services.
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2.2. Approaches of Measuring National Income (GDP/GNP)….

II. Income Approach….

We can group these factor-incomes in the following
categories:
Wages and salaries of the employees (or
compensation to employees),
Incomes of non-company business
Rental incomes of persons
Corporate profits, and
Incomes from Interest 24
2.2. Approaches of Measuring National Income (GDP/GNP)….

II. Income Approach….

 An aggregate of the above five categories of incomes will not
be equal to the GDP as estimated by the Expenditure Method.
 The reason is that a part of the total expenditure
incurred by the community does not available to the other
FOP in the form of incomes.
 There are two such leakages.
First, indirect taxes levied by the government on goods and
services like VAT, sales tax, excise tax etc.; and
Second, depreciation of machinery, plants and buildings. 25
2.2. Approaches of Measuring National Income (GDP/GNP)….

II. Income Approach….

 Therefore, while estimating the GDP by the

Income Method, we have to add indirect taxes

and depreciation charges to the factor
incomes.
 Symbolically,

and then,

Or
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2.2. Approaches of Measuring National Income (GDP/GNP)….

III. Value Added Approach

 This approach measures the value added (contribution) by
each producing entity in the production process.
 Value added is defined as the difference between total
value of the output of a firm and the value of inputs bought
from other firms.
Thus, GDP is the total value added of all firms in the
economy.

27
2.2. Approaches of Measuring National Income (GDP/GNP)….

 Generally, the following Precautions should be taken in

Measuring GDP/GNP
 Double counting should be avoided,
 Unproductive activities should be excluded e.g. transfer
payments-local transfer, pension, scholarships, and
unemployment allowance.
 Second hand and intermediate goods should be excluded,
because they are not currently produced goods & services.
 Purchase of new/old shares should be excluded because it
represents a mere transfer of property. Example:- --------- 28
 2.2. Approaches of Measuring National Income (GDP/GNP)….

Is GDP a perfect measure of National Income?

 GDP measures the market values of all goods and services
produced in the given period defined.
 Although most goods and services are valued at their
market prices when computing GDP, some productions
are not sold in the marketplace and therefore do not have
market prices.
 The following are some of the instances.

29
 2.2. Approaches of Measuring National Income (GDP/GNP)….

Is GDP a perfect measure of National Income?...

I. Housing Services: A person who rents a house is buying
housing services and providing income for the landlord;
the rent is part of GDP, both as expenditure by the renter
and as income for the landlord.
 Many people, however, live in their own homes.
Although they do not pay rent to a landlord, they are
enjoying housing services. Thus, the value of such service
is left out of GDP.
30
 2.2. Approaches of Measuring National Income (GDP/GNP)….

Is GDP a perfect measure of National Income?...

II. Home productions: some of the output of the economy is
produced and consumed at home and never enters the
marketplace. For example, meals cooked at home are
similar to meals cooked at a restaurant, yet the value
added in meals at home is left out of GDP.
III. The Underground Economy: GDP fails to account for the
value of goods and services sold in the underground
economy.
31
 2.2. Approaches of Measuring National Income (GDP/GNP)….

Is GDP a perfect measure of National Income?...

 The underground economy is the part of the economy that
people hide from the government either because they wish
to evade taxation or because the activity is illegal).
 Example: the illegal drug trade.

IV. The Informal Economy: Finally, GDP fails to consider

the value of production in the informal sector (both legal
which includes ‘Tela’, ‘Teji’, shoe repair, small scale
trade, and illegal – eg: drug dealing and prostitution).
32
 2.2. Approaches of Measuring National Income (GDP/GNP)….

Is GDP a perfect measure of National Income?...

 Because the value of many goods and services is left
unrecorded, GDP is an imperfect measure of economic
activity.
 These imperfections are most problematic when
comparing standards of living across countries.
 The size of the underground economy, for instance, varies
from country to country.

33
2.3. Other Social Accounts
 Various aggregates and concepts concerning domestic
income and national income are used in national income
accounting.
 We have learnt two of them which are GDP & GNP. Now,
we will go to other concepts related to NI.
a) Net Domestic Product (NDP) and Net National Product
(NNP):
 Net Domestic Product is the net market value of all the
final goods and services produced in the domestic
34
 2.3. Other Social Accounts
 Net national product is defined as the net production of goods
and services produced by citizens of a country during a year.
 What is left after deduction of depreciation is the net product.
Thus,

 Net products are better concepts than gross products, because

it makes proper allowance for the depreciation suffered by
capital goods during the period under consideration.
 NNP is a matter of judgment because it is difficult to measure
exactly the amount of depreciation of Capital goods. 35
2.3. Other Social Accounts
b) Net National Income at Factor Cost (NNI)
 It means the sum of all incomes earned by resource
suppliers for their contribution of FOP during the year’s
net production.
 It shows how much it costs society in terms of economic
resources to produce that net output.
 Both GNP & NNP measure the values of goods produced
in industry at the prices that those goods actually bring in
the market.
36
 2.3. Other Social Accounts
b) Net National Income at Factor Cost (NNI)….
 Here the difficulty is that when we buy these goods at market
prices, then the prices include the respective taxes on these goods
levied by the government.
 Hence, not all of the payment made for goods goes to the
people who produced them.
 Some part of it goes to the government.
 GNP/NNP does not constitute a part of the true cost of
producing the goods concerned.
 This violates the basic identity that the value of goods produced is
equal to the sum of the money incomes received by the producers. 37
 2.3. Other Social Accounts
b) Net National Income at Factor Cost (NNI)….
 the GNP will exceed the sum of money incomes received by people
of the country (resource suppliers) because of tax
 A part of the cost of government has been counted twice.
 In order to avoid double counting problems, we may introduce the
concept of net national income at factor cost.
 It is equal to net national product minus indirect tax plus subsidies.
 Mathematically:

 Where, is national income at factor cost & is net national product at

38
 2.3. Other Social Accounts
b) Net National Income at Factor Cost (NNI)….
 It indicates the nature of distribution of wealth among
various factor inputs.
 This concept is more satisfactory than the concept of
GNP and NNP, because it eliminates the element of
double counting inherent in those two concepts.
 It accords with the basic principle of economic theory, that
the payments received by the factor suppliers equal the
value of the goods produced.
39
 2.3. Other Social Accounts
c) Personal Income (PI)
 PI refers to the total income received by individuals and
households from all possible sources before personal taxes
are deducted.
 It represents the sum of all incomes actually received by
people in an economy, regardless of whether they directly
contributed to production, during a year.
 Personal Income is income received by individuals before
personal taxes are paid.
40
 2.3. Other Social Accounts
c) Personal Income (PI)….
 The government charges a withholding tax, which is used to
finance social security payments to the aged, the unemployed
and certain other persons.
 Similarly, the government makes some other transfer payments
to people of the country.
 We subtract from national income all undistributed corporate
profits, corporate income taxes and social security withholding
taxes and then add transfer payments from government and
business firms directly to persons;
41
2.3. Other Social Accounts
c) Personal Income (PI)….
 Mathematically,

Personal Income (PI) = NI – undivided corporate

Profits – Corporate Income Taxes - Social Security
Contributions + Transfer payments.

 The personal income is useful for certain special

purposes such as it shows the ability of people to pay
taxes.
 Thus, that personal income data are used for analyzing
42
 2.3. Other Social Accounts
d) Disposable personal Income (DPI)
 The main drawback of PI is that they do not tell us how
much is actually at the disposable of people for their
personal expenditure.
 DPI is the amount of income that individuals or
households have available for spending and saving after
paying direct taxes and receiving transfer payments.
 It represents the net income available to households that
can be allocated between consumption expenditure and
43
 2.3. Other Social Accounts
d) Disposable personal Income (DPI)
 Disposable personal income is the income available to persons for
spending or saving. It is calculated as personal income minus
personal current taxes. (U.S. Bureau of Economic Analysis,
2018)
 Thus,
 Disposable income data are useful for studying the purchasing power
of the consumers and for making further analysis on consumption
and saving behaviour of an individual in the economy.

44
 2.4. Nominal GDP Versus Real GDP
 GDP is the total value of goods and services produced in
the economy measured at market price.
Is GDP a good measure of economic well-being?
What is well-being economy?
What we mean by market prices?
 When we say market prices, we can measure GDP by the
currently prevailing market prices or at some base year
prices.

45
 2.4. Nominal GDP Versus Real GDP
 Economic well-being refers to the overall standard of
living and financial security enjoyed by individuals or
society.
 It measures how well people can satisfy their needs and
wants through income, wealth, and access to essential
goods and services.
 It includes both present and future financial security, the
ability to meet basic needs, and the freedom to make
economic choices for personal satisfaction.
46
2.4. Nominal GDP Versus Real GDP
Key Dimensions of Economic Well-being
Income Level: Ability to earn and spend on basic and
non-basic needs.
Employment: Availability of stable and rewarding jobs.
Wealth: Ownership of assets like property or savings.
Access to Goods & Services: Education, healthcare,
housing, and transportation.
Economic Security: Protection against unemployment
and inflation.
47
 2.4. Nominal GDP Versus Real GDP
Nominal GDP
 It refers to the market value of goods and services
measured at current prices.
 It increases when prices rise or when quantities rise.
 It is not a good measure of economic well-being as it does
not adjust for price changes.
 Example: If all prices double while quantities remain
constant, nominal GDP doubles, but the economy’s real
output does not change.
48
 2.4. Nominal GDP Versus Real GDP
Real GDP
 It measures the value of goods and services using constant
base-year prices.
 Adjusted for inflation, showing only changes in real
output.
 Real GDP changes only when quantities produced change,
not prices.
 Provides a better indicator of economic performance and
well-being.
49
2.4. Nominal GDP Versus Real GDP
Comparison: Nominal GDP vs. Real GDP
Measure Definition Price Basis Usefulness
Nominal GDP Value of goods Current-year Reflects
and services at prices changes in
current prices. price and
output.
Real GDP Value of goods Base-year Reflects
and services at prices changes in
constant base- output only.
year prices.

Key Use Assess true - Better indicator

growth and of economic
living performance. 50
 2.5. The GDP Deflator and the Consumer Price Index
How can we measure price level?
 We can use three indices to measure prices over time: The
GDP Deflator, the Consumer Price Index (CPI) and the
producer price index, among which the GDP deflator and
CPI are widely applicable.
 The GDP Deflator
 The GDP deflator reflects what’s happening to the overall
level of prices in the economy.
 The GDP deflator is defined as the ratio of nominal GDP
51
 2.5. The GDP Deflator and the Consumer Price Index
The GDP Deflator..…
 Mathematically, GDP Deflator
 The GDP deflator measures the price of output relative to its
price in the base year.
 The GDP deflator is used to deflate nominal GDP to yield real
GDP.
 Nominal GDP measures the current currency value of the output
of the economy whereas real GDP measures output valued at
constant prices.

𝑁𝑜𝑚𝑖𝑛𝑎𝑙𝐺𝐷𝑃=𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 ×𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 52

 2.5. The GDP Deflator and the Consumer Price Index
The Consumer Price Index (CPI)
 The most commonly used measure of the general price level is
the consumer price index (CPI).
 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.
 The CPI is the cost of basket of goods and services relative to the
cost of the same basket in some base year.
 The CPI measures how average consumer prices change over
53
 2.5. The GDP Deflator and the Consumer Price Index
The Consumer Price Index (CPI)…….
 We can calculate CPI as follow:
Cost of Basket in Current Year
𝐶𝑃𝐼 = ∗ 100
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐵𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟
 Example: Suppose the typical consumer’s basket includes 5 apples
& 2 oranges each month and their respective prices are as follow:
Item Quantity Price (2023) Price (2024)
Apples 5 $2 each $3 each
Oranges 2 $4 each $5 each

 Calculate consumer price index for 2024.

 Solution ………..
54
 2.5. The GDP Deflator and the Consumer Price Index
 The CPI Versus the GDP Deflator
 There are two key differences between the two measures.
I. Scope of Goods and Services
 The GDP deflator measures the prices of all goods and
services produced domestically.
 The CPI measures the prices of goods and services purchased
by consumers.
 Therefore, an increase in the price of goods bought by firms or
the government appears in the GDP deflator, but not in the
CPI. 55
 2.5. The GDP Deflator and the Consumer Price Index
 The CPI Versus the GDP Deflator …….
II. Domestic vs. Imported Goods
 The GDP deflator includes only domestically produced
goods and services.
 Imported goods are excluded from GDP and hence from
the GDP deflator.
 In contrast, imported goods are included in the CPI if they
are part of consumers’ purchases.
 Example: An increase in the price of a Toyota made in
Japan and sold domestically raises the CPI (since
consumers buy it), but not the GDP deflator (since it is not
produced domestically).
56
2.5. The GDP Deflator and the Consumer Price Index
 The CPI Versus the GDP Deflator …….
 Comparison: CPI vs. GDP Deflator

57
 2.6. GDP and Welfare
Does a rise in GDP guarantees improvement in living
standard of societies?
 GDP can be taken as a rough measure of standard of
living.
 This is because “Standard of living” is a broader term than
GDP.
 While GDP focuses on production that is bought and sold
in markets, standard of living includes all elements that
affect people’s well-being, whether they are bought and
58
 2.6. GDP and Welfare….
 The following are some of the limitations of GDP as a Measure of
society’s well-being.
 GDP is a gross measure and has nothing to say about the
distribution of income in society.
 It does not indicate how the total national income is actually
distributed among the population of a nation.
 For instance, if GDP is highly unequally distributed among
nationals where a small portion of the population earns the
significant portion of national output, mass of the population may
remain impoverished despite rapid growth in GDP.
 So, higher GDP doesn’t guarantee improvement in living standard. 59
 2.6. GDP and Welfare….
 While GDP includes what is spent on environmental protection,
healthcare, and education, it does not include actual levels of
environmental cleanliness, health, and learning.
 GDP includes the cost of buying pollution-control equipment,
but it does not address whether the air and water are actually
cleaner or dirtier.
 GDP fails to consider costs of environmental damage to
society: where an increase in GDP may be made possible at a
cost of environmental degradation (reduction in forest,
depletion of mineral resources & wild lives).
60
 2.6. GDP and Welfare….
 GDP includes spending on medical care, but does not address
whether life expectancy or infant mortality have risen or fallen.
 Similarly, it counts spending on education, but does not address
directly how much of the population are literate.
 GDP does not include non-market productions: hiring someone
for home activities like house cleaning, food preparation and
child care at home are production, but left out from GDP.
 GDP fails to account for Crime rates: If people are led by a
rising fear of crime, it is hard to believe that an increase in GDP
has made them better off
61
 2.7. The Business Cycle
 It refers to the recurrent ups and downs in the level of
economic activity.
 Countries usually experience ups and downs in the level of
total output and employment over time.
 With the fluctuation in the overall economic activity, inflation
and unemployment have also clear cyclical patterns.
 Therefore, a business cycle is a fluctuation in overall economic
activity, which is characterized by the simultaneous expansion
or contraction of output in most sectors.

62
2.7. The Business Cycle ….

Figure: Business cycle

63
 2.7. The Business Cycle ….
 The trend growth of GDP is the path GDP would take
if factors of production were fully employed.
 Over time, real GDP changes for two reasons:
i. More resources become available which allows the
economy to produce more goods and services,
resulting in a rising trend level of output.
ii. 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 the64
 2.7. The Business Cycle ….
 Deviations of output from trend are referred to as the
output gap.
 The output gap measures the gap between actual output
and the output the economy could produce at full
employment given the existing resources.
 Full employment output is also called potential output.

65
 2.7. The Business Cycle ….
 We can identify four phases in the business cycle:

I. Boom / Peak Phase

Highest point of the business cycle.
Economy operating near full capacity.
Characteristics:
 High output and income levels.
 Low unemployment.
 Strong business performance.
 Marks transition from expansion to recession. 66
2.7. The Business Cycle ….
II. Recession / Contraction Phase

Economic performance declines.

Total output and business activity fall.

Unemployment rises.

Severe and prolonged recessions lead to

depression or trough.

Causes hardship for businesses and citizens.

67
2.7. The Business Cycle ….
III. Trough / Depression Phase
Lowest point of economic activity.
Marks end of recession and start of recovery.
Features:
 High unemployment.
 Idle productive capacity.
 Weak consumer demand.

68
2.7. The Business Cycle ….
IV. Recovery / Expansion Phase

Economic growth resumes/starts grow up.

Increasing employment and output.

National income rises.

When expansion reaches its maximum, the economy

enters another boom.

69
2.8. Inflation
What is inflation? And what causes inflation?
 Inflation is continuous increase in the overall price level.
 Measured by:
 Consumer Price Index (CPI)
 GDP Deflator
 Results in a loss of purchasing power of money.
 Described as “too much money chasing too few goods.”
 Overall or General:- affects most goods/services, not isolated
items.
Continuous Rise:- sustained over time, not one-time increases.
70
2.8. Inflation…..
Types of Inflation (by Magnitude)
a) Creeping Inflation (<3% per year): Safe, can promote
growth.
b) Walking Inflation (3–10%): Warning signal for
policymakers.
c) Running Inflation (10–20%): Hurts poor/middle
classes; requires control.
d) Hyperinflation (>50% per month): Monetary system
collapse.
71
2.8. Inflation…..
 Causes of Inflation: Two Broad Categories:

a) Demand-Pull Inflation
b) Cost-Push Inflation
a. Demand-Pull Inflation
Caused by excessive aggregate demand over aggregate
supply.
When GDP grows faster than potential GDP.
Inflationary gap occurs: AD > AS at full employment.

72
2.8. Inflation…..
 Causes of Demand-Pull Inflation
Depreciation of currency→ exports rise, demand increases.
Government fiscal stimulus→ tax cuts or higher spending.
Monetary stimulus→ lower interest rates raise borrowing and
demand.
Stronger foreign demand→ boosts exports.

b. Cost-Push Inflation
Caused by rising production costs leading to higher prices.
Firms raise prices to maintain profit margins.
73
2.9. Unemployment
 An economy’s workers are its chief resource, keeping
workers employed is a paramount concern of
macroeconomists and policymakers.
 As defined by ILO (1998), unemployment represents the
portion of nation’s labor force (working age group) that are
willing and able to work but without jobs.


74
2.9. Unemployment….

Indicates the share of working-age population engaged in labor
market activity.
Growth-Unemployment Dynamics: Okun’s Law

 Describes the inverse relationship between unemployment and GDP

growth.
 Okun’s Law: %ΔRGDP = 3% - 2 × %ΔU
 Example: If unemployment rises from 6% to 8%, GDP falls by 1%.
 Indicates that rising unemployment signals recession.

75
2.9. Unemployment….
 Okun’s law states that for every percentage point the

unemployment rate rises, real GDP growth typically falls

by 2 percent.
 Okun’s law says that GDP would fall by 1 percent,
indicating that the economy is in a recession.
Okun’s Law (Formal Version)

Output above natural rate ():- unemployment below

natural rate ).
Output below natural rate ():- unemployment above
natural rate ). 76
2.9. Unemployment….
 Graphically:-

77
2.9. Unemployment….
Inflation-Unemployment Dynamics: The Phillips Curve
 Low inflation and low unemployment are two goals of
economic policymakers, but often these goals conflict.
 The Phillips curve named after New Zealand economist Alban
William Phillips (who observed it first) describes this type of
empirical relationship between inflation and unemployment.
Phillips curve shows inverse relationship between inflation and
unemployment.
The Phillips curve in its modern form states that the inflation
rate depends on three forces: 78
2.9. Unemployment….
Expectations-Augmented Phillips Curve
Equation: π = πᵉ - β(u - uⁿ) + v
Where:
πᵉ = expected inflation
(u - uⁿ) = cyclical unemployment
v = supply shocks
If πᵉ = π₋₁ (adaptive expectations):

Implications:
High unemployment → reduces inflation.
Low unemployment → raises inflation.
Supply shocks → shift the curve.
79
2.9. Unemployment….

Downward-sloping short-run Phillips Curve.

Trade-off between inflation and unemployment.
Long-run Phillips Curve is vertical at natural rate of
unemployment. 80
2.9. Unemployment….
Phillips Curve: Policy Implications
 Expansionary policy→ reduces unemployment, raises
inflation.
 Contractionary policy→ reduces inflation, increases
unemployment.
 Policymakers must balance growth and price stability.

81
2.9. Unemployment….
Summary
Scenario (u − uⁿ) v Result Type

Overheatin Inflation > Demand-

Negative 0
g economy Expected pull

Inflation <
Recession Positive 0 Disinflation
Expected

Cost-push
0 Positive Inflation ↑ Cost-push
shock

Favorable
Deflationar
supply 0 Negative Inflation ↓
y pressure
shock
82
 End of Chapter Two!

Thank you for giving me your

Attention!

Next Chap 3: AD in Closed Economy

11/30/2025 83