CHAPTER TWO

2.0 NATIONAL INCOME ACCOUNTING

The aggregate performance of a large and complex economic system requires some standards by
which to measure that performance. Unfortunately, our systems of national income accounting
are imperfect and provide only rough guidelines, rather than clear measurements of the economic
performance of large systems. As imperfect as the national income accounting methods are, they
are the best measures we have and they do provide substantial useful information. The purpose
of this chapter is to present the measures we do have for aggregate economic performance.

In this chapter mainly we focus on the three statistics that economists and policymakers use most
often. Gross domestic product, or GDP, tells us the nation’s total income and the total
expenditure on its output of goods and services. The consumer price index, or CPI, measures the
level of prices. The unemployment rate tells us the fraction of workers who are unemployed. We
see how these statistics are computed and what they tell us about the economy.

2.1 The Concepts of Gross Domestic Product and Gross National Product

Gross Domestic Product (GDP)

Up to now, we have been somewhat careless in using the phrase “domestic product.” Let’s now
get more specific. Of the various ways to measure an economy’s total output, the most popular
choice by far is the gross domestic product (GDP) for short-a term you have probably
encountered in the news media. GDP is the most comprehensive measure of the output of all the
factories, offices, and shops in a given country. To compute GDP for a given economy, it will be
helpful to have a more precise definition: gross domestic product (GDP) is the market value of
all final goods and services produced within an economy in a given period of time.

Several features of this definition need to be underscored.

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

The GDP consists of a combination of variety of goods and services: computer chips and potato
chips, tanks and textbooks, and so on. How can we combine all of these into a single number? To

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an economist, there is a natural way to do so: First, convert every good and service into money
terms, and then add all the money up. Thus, we can add apples and oranges together. To add 10
apples and 20 oranges, first ask: How much money does each cost? If apples cost 20 cents and
oranges cost 25 cents, then the apples count for 2 Birr and the oranges for 5 Birr, so the sum is 7
Birr worth of “output.”

The market price of each good or service is used as an indicator of its value to society for a
simple reason: Someone is willing to pay that much money for it. This decision raises the
question of what prices to use in valuing different outputs. We have two choices on this regard.
Most obviously, we can value each good and service at the price at which it was actually sold. If
we take this approach, the resulting measure is called nominal GDP or GDP in current prices.
This seems like a perfectly sensible choice, but it has one serious drawback as a measure of
output: Nominal GDP rises when prices rise, even if there is no increase in actual production. For
this reason, we have devised alternative measures that correct for inflation by valuing goods and
services produced in different years at the same set of prices. We call it real GDP or GDP in
constant dollars. The news media often refer to this measure as “GDP corrected for inflation.”
We have a detailed discussion of these alternatives in section 2.4.

ii. What gets counted in GDP?

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

a. In a given period of time: the GDP for a particular year includes only goods and services
produced within that year. Sales of items produced in previous years are explicitly
excluded. The same is true of houses. The resale values of houses do not count in GDP
because they were counted in the years they were built.
b. Final goods and services: Next, you will note from the definition of gross domestic
product that only final goods and services (are those that are purchased by their ultimate
users (consumers)) count in the GDP. The adjective final is the key word here.
For example, suppose that a loaf of bread (a final good) is produced with flour (an
intermediate good). It would not make sense to add the value of flour separately in the
calculation of GDP since the flour has been ‘consumed’ in process of making bread and
since the market price of bread already reflects the value of the flour that was used in its
production. Thus, GDP excludes sales of intermediate good and service (is a good
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 purchased for resale or for use in producing another good) because, if they were included,
we would wind up counting the same outputs several times “double counting.”
The concept is straightforward, but the measurement problems can be complex. For
example, a given product, say, sugar, can be used as a final product or as input into
further production processes. Thus, this requires a mechanism for distinguishing between
the sugar bought for household consumption and the sugar purchased for further
production.
c. Domestic economy: The adjective domestic in the definition of GDP denotes production
within the geographic boundaries of a given country. For example, some Ethiopians work
abroad, and some of them have offices or factories in foreign countries. Although all of
these foreign employees of Ethiopian firms produce valuable outputs, none of it is counts
in the GDP of Ethiopia. (It counts, instead, in the GDPs of the other countries.) On the
other hand, quite a lot foreign companies produce goods and services in Ethiopia. All that
activity of foreign firms on our soil does count in our GDP.
d. Underground economy and nonmarket transaction: For the most part, only goods and
services that pass through organized markets count in the GDP. This restriction, of
course, excludes many economic activities. For example, illegal activities are not
included in the GDP. This reflects the inability to measure the value of many of the
economy’s most important activities, such as housework, repairs, and others. These
activities certainly result in currently produced goods or services, but they all lack that
important measuring rod—a market price.

Gross National Product (GNP)

One could alternatively define an economy as consisting of all production units that belong to a
country (whether or not these production units reside in the country or not). For an economy
defined in this way, the value of production is called the Gross National Product (GNP). It is the
most comprehensive measure of a nation’s productive activities. It is defined as the value of all
final goods and services produced by citizens of a country during a specific period, usually one
year, irrespective of their place of residence. It refers to that part of the GDP that is actually
produced and earned by or transferred to resident nationals of that country. It measures output
produced by the labor and property of citizens, regardless of where the labor and property are

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located. On contrary, earnings of foreigners which arise out of their domestic economic activities
are thus excluded.

For Ethiopians working abroad their income is included in the GNP of Ethiopia. Where there is
substantial foreign participation in the economy and a large part of total domestic income is
earned and repatriated by foreigners and foreign companies as in many LDCs, GDP will be much
larger than GNP. As a result statistics of GDP growth may give a false impression of the
economic performance of a particular developing nation.

2.2 Approaches of Measuring National Income (GDP)

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

of measuring national income. The national income estimates provide not only a single figure
showing the national income, but also supply the detailed figure with regard to the various
components of the national income. It is both the figure of national income and the details
regarding its constituents that throw light on the functioning and performance of the economy.
The following are some of the important uses of national income estimates.
i. Assists government in planning the economy. The account shows growth or
stagnation in the economy, alerting policymakers to the sort of action which ought to
be taken. Since national income accounts break the performance of the economy
down into its component parts, they provide policymakers with specific information
regarding the formulation and application of economic policy.
ii. Permits us to measure the level of production in the economy over a given period of
time and to explain the immediate causes of that level of performance.
iii. By comparing the national income accounts over a period of time, the long-run course
(growth path) which the economy has been following can be plotted.
iv. Help us to compare standards of living of different countries
v. As a measure of welfare and national development, real GNP per capita may be rising
over a period of time implying a rise in economic welfare and economic
development.

Once we have agreed on the importance of estimates of national account, next, we discuss the
three alternative approaches (methods) for measuring total output, namely:

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 i. Expenditure Approach
ii. Income Approach
iii. Value Added or Output Approach

The Expenditure Approach

Expenditure approach-involves only counting the value of those transactions where a commodity
reaches its final destination. The market for consumer goods is by implication the market where
final goods and services are sold.

Measuring total output by the expenditure method involves breaking down total spending on all
goods and services produced into four categories:

i. Expenditures by consumers on goods and services (abbreviated simply to the letter, C);
ii. Expenditures by businesses on capital goods (total investment spending, I);
iii. Expenditure by government on goods and services, G); and
iv. Net exports (the total value of exports minus the total value of imports, X-M).

Because all spending done in the country falls into one or other of these four categories, we can
say that total expenditure is the sum of C+I+G+(X-M). We now examine each of these four main
components of total spending.

Consumption (C)

Consumption spending is the total of all outlays made by households on final goods and services.
In all countries it is by far the largest component of total spending. It covers spending on an
enormous range of items, including durable goods like television sets and cars, non-durable
goods like food and clothing, and personal services such as legal advice, haircut, doctor visit, and
dental care. But it usually excludes spending on houses, which is customarily (and arbitrarily)
treated as investment expenditure. Consumption also excludes purchases of second-hand goods
that were produced in some earlier accounting period so as not to double count the value of such
output.

Investment (I)

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Investment is the production of goods that are not for immediate consumption. These goods are
called investment goods (inventories and capital goods including residential housing). The total
investment in an economy is called Gross Investment.

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

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

equipment either to replace existing capacity that is wearing out or to increase
capacity. This is often called fixed capital formation.
ii. Residential investment: We count the construction of new houses as part of GDP, but
we do not add trade in existing houses. We do, however, count the value of the estate
agents commission in the sale of existing houses as part of GDP. The estate agent
provides a current service in bringing buyer and seller together, and that is
appropriately part of current output.
iii. Expenditure on inventories: Many businesses find it convenient or necessary to hold
certain supplies of goods on hand, in which case investment in inventories may be
considered voluntary. But business conditions are uncertain and so firms may also
find themselves holding stocks because they miscalculated demand. In either case,
firms are considered to be investing when they accumulate inventories. On the other
hand, if their inventories decrease they are "disinvesting." Inventory investment is
highly volatile, changing greatly in amount and composition from year to year.

Gross investment, then, is the total amount of (usually private) spending during the accounting
period on capital goods (defined as structures, machinery and equipment, and inventories).
Because capital by its nature consists of things that are used in the production of other goods and
services, it is inevitable that it will wear out or "depreciate." The amount necessary for
replacement is called Depreciation or capital consumption allowance. Gross Investment –
Depreciation = Net Investment. Unless it is continually renewed, the stock of capital in the
economy will gradually be depleted.

Handling depreciation is one of the more difficult parts of national income accounting. Again,
the best treatment depends on what the data are meant to be used for. If the concern is with the
long-term growth of the economy, net investment (total investment during the accounting period
minus depreciation) is the important concept because it measures the growth of the economy’s
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capital stock over time. But if the purpose is to understand short term, annual fluctuations in the
level of total spending it is better to work with gross investment.

Government Expenditure on Goods and Services (G)

All governments, federal, regional and local governments, payments to factors of production in
return for factor services rendered are counted as part of the GDP. Much of the spending done by
governments in the developed countries today takes the form of simple transfers of income from
taxpayers to those eligible for the wide range of income supplements available to assist the
elderly, the sick and the unemployed, or as payments of interest to holders of the public debt.
Because such transfer payments reallocate existing income and are not made in exchange for
goods and services, they are not part of GDP. What is counted is government spending on goods
and services, many of which are bought by the government on behalf of the public and which are
ultimately "consumed" by households: education, health care services, national defense, roads,
water and sewage systems, postal services.

Thus, if you receive a wage from the government because you are a teacher, your wage is a
factor payment and would be included in GDP. If you receive a welfare payment because you are
poor, the payment is not in return for service but is a transfer payment and would be excluded
from GDP.

The same holds true for interest payment on the government debt. Interest is treated as a payment
for debt incurred to pay for past wars or government programs and is not considered to be a
purchase of a current good or service. Government interest payments are considered as transfers
and therefore omitted from GDP.

Thus, do not confuse the way the national accounts measure government spending on goods and
services (G) with the official government budget. When the Treasury measures its expenditures,
it includes purchase of goods and services (G) plus Transfers.

There are two complications concerning government expenditures:

i. Because so many of these goods and services are provided "free" or in other ways that
bypass markets, it is difficult to determine their value in the same way that the value
of the other items entering into C would be determined. Consequently, national

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 income accountants value government spending on the basis of what the government
pays for the goods and services it requires- based on imputed value at cost of
providing services.
For example, police officers, firefighters, and city mayor provide services to the
public. Giving a value to these services is difficult because they are not sold in a
marketplace and therefore do not have a market price. The national income accounts
include these services in GDP by valuing them at their cost. That is, the wages of
these public servants are used as a measure of the value of their output.
ii. Government expenditure on goods and services is that such spending is often done on
things like highways which are capable of being used to assist in the production of
other goods. Logically, such spending should be thought of as investment spending.
Some countries produce their accounts in such a form that government spending can
be separated into two categories, current spending on goods and services, and
investment spending.

Net Exports (X-M)

The External Sector Exports (X) represents an addition to domestic expenditure and must be
added to it in order to arrive at an indication of aggregate demand or aggregate expenditure.
Imports (M) are a subtraction from domestic expenditure. An increase in imports (M) lowers
aggregate demand and hence employment whereas a rise in exports (X) has the opposite effect.

For example, production differs from sales in Ethiopia in two respects. First, some of our
production (coffee and oil seeds) is bought by foreigners and shipped abroad, and these items
constitute our exports. Second, some of what we consume (Arabian oil and Indian car) is
produced abroad and shipped to Ethiopia, and such items are Ethiopian Imports.

A significant part of total spending in most countries goes toward the purchase of goods
produced abroad rather than domestically. As noted in discussing the circular flow, such outlays
represent spending which leaks from the domestic economy to the rest of the world and is
consequently treated as a negative entry in measures of total domestic spending. But it is offset
to a greater or lesser degree by the spending of non-residents on goods produced and exported to
international markets. It is often convenient, therefore, to take domestic spending on imports and
foreign spending on exports as a combined value, usually called net exports, a value which may
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be positive or negative in any accounting period depending on which component, exports or
imports, is larger.

Summing these four expenditure components, C+I+G+(X-M), gives a single figure, the total
amount of spending done in the economy during the accounting period. GDP = Y = C+I+G+(X-
M)

Numerical Examples

1. We can use a simple farming economy to understand how the national accounts work. Suppose
that out of the total amount produced and 7 imported, 87 quintals are consumed (in C), 10 go for
government purchases to feed the army (as G), and 6 go into domestic investment as increases in
inventories (I). In addition, 4 quintals are exported.
What, then, is the composition and amount of GDP of this agrarian economy?

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

GDP=100 quintals

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

Personal Consumption Expenditure (C) 3658.10

Gross Private Domestic Expenditure (I) 745
Government Purchases of Goods & Services (G) 1098
Export 670
Import 708
What is the value of GDP?
GDP = C + I + G + NX
GDP = 3658.10 + 745 + 1098 + (670-708)
GDP = 5463.10
3. Suppose the following describes the economy (all figures in billions)

GDP 9000 birr

Investment 1500
Consumption 5000
Government purchases of goods and services 1000

What is the value of net export?

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 GDP= C + I + G + NX
9000 = 5000 + 1500 + 1000 + NX
NX = 9000- 7500
NX = 1500 birr

Income Approach

Income approach involves calculation of GDP by summing up all incomes that derived from the
production process. In other words, it includes all payments made in respect of the four factors of
production, namely labor, capital, land and entrepreneurship over a given period of time. This
implies that the total of all wages and salaries, interest, rent and profits is conceptually equal to
the GDP as calculated according to the production method.

In principle output expressed in monetary terms must be equal to the total monetary income
deriving from it (i.e. value of final goods and services = Total income). As in the circular flow,
what the firms producing the national output see as costs of production, owners of productive
factors see as income. Factor costs and factor incomes are consequently the same thing viewed
from different perspectives.

The national income accounts divide incomes into five categories: compensation of employees,
rental income, proprietors’ income, net interest, and corporate profits. Compensation of
employee is the most important and certainly the simplest factor costs to measure. It is the
payments that made by employers for labor services. These payments are include Wages,
salaries, and supplementary labor income which referring to employee benefits such as pensions,
workers’ compensation benefits, and employer contributions to unemployment insurance funds
or other worker social security schemes. Rental income is the income that received for owning
property by property owners. It includes rent payments received by landlords, royalty payments
from patents and copy rights as well as imputed rent that homeowners “pay” to themselves.
Similarly, the household receive interest income for exchange in capital. The net interest is the
interest that the domestic businesses pay minus the interest they receive.

Profit is a residual left after paying for rent, interest on debt, and employees’ compensations and
other costs. There are two kinds of profits in national income accounts: earning of incorporated
enterprises (proprietors’ income) and profit of corporation (corporate profit). Proprietors’ income

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consists of earning of partnership and single owned business firms or earning of incorporated
businesses in general. Finally, corporate profit is the income of corporations after payments to
their workers and creditors. It includes corporate profit taxes, dividends, and undistributed
corporate profits; the latter is what corporations retained in to business and is called ‘net
corporate saving.’

The sum of these five income components gives as the net domestic income at factor cost. But if
this figure for factor costs or income is compared with the total arrived at by the expenditure
method, it falls considerably short of the amount expected. Thus, two adjustments must be made
to get GDP at market prices:

i. Indirect taxes minus subsidies are added to get from factor cost to market prices. In
order to estimate GDP at market price it is therefore necessary to add indirect taxes to
GDP at factor cost, since the market price exceeds GDP at factor cost by this amount.
Similarly, subsidies are paid to the producer and therefore form part of factor income
but not of the market price; for this reason it is subtracted from GDP at factor cost to
reach at GDP at market price. We therefore have to add indirect taxes from the GDP
at factor costs and deduct subsidies.
ii. Depreciation (or capital consumption allowance) is added to get from net domestic
product to gross domestic product.

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

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

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

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 Compensation of employees 3244.20
Proprietor’s income 402.40
Rental income of persons 6.70
Corporate profits 297.10
Net interest 467.10
Deprecation 575.70
Indirect business taxes (IBT) 469.90
a. What is the value of net domestic product at factor cost?
b. What is the value of GDP at market price?
Solution:
a. Net domestic product = compensation of employees + rental income +

proprietors’ income + net interest + corporate profits

= 3244.20 + 6.70 + 402.40 + 467.10 + 297.10

= 4417.50

b. GDP at market price = net GDP at factor cost + indirect business taxes +
Deprecation
= 4417.50 + 575.70 + 469.90

= 5463.10

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

Transfer Payments $54

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

Solution:

a. GDP using expenditure approach

GDP = household consumption + Gross private investment + government
purchases + net exports
GDP = 304 + 124 +156 + 18 = 602
b. GDP using income approach
GDP = wages + rental income + interest income + business profit +
indirect business taxes + depreciation
= 67 + 75 + 150 + 200 + 74 + 36
= 602
c. Both approaches yield the same level of GDP, which is true by the definition.

Output or the Value Added Approach

A third method is available for estimating the total output of the economy and it is called the
"value added method" because it simply sums the net value (value added) of the output produced
by all firms in the economy. This approach measures GDP in terms of values added by each
sector of economy.

There are many interactions among firms in a modern economy. Many produced goods are sold
not to final users as consumer goods, but to other firms. Consider a firm producing power supply
devices for computers. It buys components from suppliers, assembles them, and sells the finished
product to another firm which incorporates it into a computer. If the value of the power supplies
was measured when they were produced and again as part of the price of the finished computer,
total output would obviously be exaggerated.

The value added by any one business is equal to the total value of the firm’s products minus that
value of the materials and intermediate goods the firm purchases. In computing value added from
the start to finish, each intermediate good and service enters the calculation twice: once with the
plus sign, when the value added of the business that made the good is calculated, and once with a
minus sign, when the value added of the business that uses the good calculated. Using this value-
added approach, every good and service in the economy cancels out except those that are sold to
other businesses for use in the production process. The goods whose values do not cancel out are
the final goods and services-consumption goods, goods purchased by the government, goods
purchased as part of investment, and net exports. In formula terms:

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

If we follow the course of this process, we will see that the sum of values added at each stage of
process is equal to the final value of the item sold.

Numerical Example
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1. Consider the following bread production process:

Stages of production Sales receipts Cost of intermediate products

Wheat 100 0
Flour 200 100
Final product: bead 300 200
a. Find the value added at each stages of production
b. Find GDP using value added approach
c. Find GDP as the value of final product

Solution:

a. Value at each stage of production can be obtained by subtracting sales receipt from cost of
intermediate products

Stages of production Sales receipts Cost of intermediate Value added

products
Wheat 100 0 100-0 = 100
Flour 200 100 200-100 = 100
Final product: bead 300 200 300-200 = 100
Total 600 300
b. GDP using value added approach = (100-0) + (200-100) + (300-200)
=300
c. GDP at the value of final product= 300.

2. The small economy of Pizzania produces three goods (bread, cheese, and pizza), each produced
by a separate company. The bread and cheese companies do not buy inputs. The pizza company
uses the bread and cheese from the other companies to produce pizza. All three companies use
capital and labor to produce output.

Input/ Bread Cheese Pizza

output company company company
Input costs 0 0 50(bread), 35(cheese
Wages 15 20 75
Interest 20 10 20
Value of output 50 35 200
a) Calculate GDP using the value added approach
b) Calculate GDP using the expenditure approach
c) Calculate GDP using the income approach
d) Do your GDP estimates agree? Why or why not?

Solution:

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

b) Using expenditure approach GDP is value of final product
GDP = value of final product Pizza

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 GDP = 200
c) GDP = (15+20+(50-20-15-0))+(20+10+(35-10-20-0))+(75+20+(200-
75-20-(50+35)))
= (15+20+15) + (20+10+5)+(75+20+(200-75-20-85))
= 50 + 35 + (75 + 20 + 20)
= 50 + 35 + 115
= 200
d) Yes, they should be by definition.

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

The national income accounts include other measures of income that differ slightly in definition
from GDP. It is important to be aware of the various measures, because economists and the press
often refer to them.

To see how the alternative measures of income relate to one another, we start with GDP and add
or subtract various quantities.

Gross National Product (GNP): GNP measures the total income earned by residents of an
economy from engaging in various economic activities, irrespective of whether the economic
activities are carried out within the economic territory or outside, in a specified period of time,
usually one year.

To obtain gross national product (GNP), we add receipts of factor income (wages, profit, and
rent) from the rest of the world and subtract payments of factor income to the rest of the world:

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

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

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

Under what situation GDP is greater than GNP? GDP becomes greater than GNP when income
earned by non-residents locally is greater than income earned by residents abroad, or when NIA
is negative.

Net National Product (NNP): To obtain net national product (NNP), we subtract the
depreciation of capital—the amount of the economy’s stock of plants, equipment, and residential
structures that wears out during the year:

NNP = GNP − Depreciation.

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In the national income accounts, depreciation is called the consumption of fixed capital. Because
the depreciation of capital is a cost of producing the output of the economy, subtracting
depreciation shows the net result of economic activity.

National Income (NI): The next adjustment in the national income accounts is for indirect
business taxes, such as sales taxes. These taxes place a margin between the price that consumers
pay for a good and the price that firms receive. Because firms never receive this tax margin, it is
not part of their income. Once we subtract indirect business taxes from NNP, we obtain a
measure called national income:

National Income = NNP − Indirect Business Taxes

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

Personal Income (PI): A series of adjustments takes us from national income to personal
income, the amount of income that households and non-corporate businesses receive. Three of
these adjustments are most important.

i. First, we reduce national income by the amount that corporations earn but do not pay
out, either because the corporations are retaining earnings or because they are paying
taxes to the government. This adjustment is made by subtracting corporate profits
(which equals the sum of corporate taxes, dividends, and retained earnings) and
adding back dividends.
ii. Second, we increase national income by the net amount the government pays out in
transfer payments. This adjustment equals government transfers to individuals minus
social insurance contributions paid to the government.
iii. Third, we adjust national income to include the interest that households earn rather
than the interest that businesses pay. This adjustment is made by adding personal
interest income and subtracting net interest.

Thus, personal income is

Personal Income = National Income

− Corporate Profits

− Social Insurance Contributions

− Net Interest

+ Dividends

+ Government Transfers to Individuals

+ Personal Interest Income.

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Disposable Income (DI): Next, if we subtract personal income tax payments and certain non-tax
payments to the government (such as parking tickets), we obtain disposable personal income.

Disposable Personal Income

= Personal Income − Personal income Tax and Nontax Payments

Disposable personal income is the amount the households and non-corporate businesses have available to
spend after satisfying their tax obligations to the government.

Numerical Example

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

Undistributed corporate profits 40

Personal consumption expenditures 1345
Compensation of employees 841
Net interest 142
Export 60
Indirect business taxes 90
Government expenditures 560
Government transfers to individuals 60
Rental income 115
Personal income taxes 500
Imports 75
Proprietors income 460
Personal interest income 10
depreciation 80
Corporate income taxes 100
Net investment 120
Dividends 222
Net income earned from abroad 5
Social security contributions 70
Solution

i. GDP using expenditure approach

GDP= personal consumption expenditures + gross private domestic investment + government
expenditures + (gross export – gross import)
GDP = 1345 + (120 + 80) + 560 + (60-75)
GDP = 1345 + 200 + 560 + (-15)
GDP = 2090

GDP using income approach

GDP = (compensation of employees + rents + interest + proprietors income + (corporate
income taxes + dividends + undistributed corporate profits)) + (indirect business taxes-
Subsidies) + depreciation
GDP = (841 + 115 + 142 + 460 + (100 + 222 + 40) + (90-0) + 80
GDP = (841 + 115 +142 + 460 + 362) +90 +80
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 GDP = 1920 + 90 + 80
GDP = 2090
ii. GNP = GDP + Net factor income from abroad (NFIA)
GNP = 2090 + 5 = 2095
iii. NNP = 2095 – 80 = 2015
iv. NI = NNP − Indirect Business Taxes
NI = 2015- 90
NI = 1925
v. PI = NI − Corporate Profits − Social Insurance Contributions − Net Interest + Dividends +
Government Transfers to Individuals + Personal Interest Income
PI = 1925 – 362 – 70 – 142 + 222 + 60 + 10 = 1643
vi. DI = PI – Personal income taxes
DI = 1643 – 500 = 1143

2.4 Nominal versus Real GDP

We have defined GDP as the dollar value of goods and services. In measuring the birr value of
GDP, we have used the measuring rod of market prices for the different goods and services
produced. But prices change over time, as inflation generally sends prices upward year after
year. This problem of changing prices is one of the problems that economists have to solve when
they use market price as a measuring rod (yardstick). Thus, they have to replace with a reliable
measure by removing the price-increase components so as to create a real or quantity index of
national output.

Here as a basic idea two measures of GDP are known: nominal GDP (also called current dollar
GDP) and real GDP (constant dollar GDP). Nominal GDP measures the value of output at the
prices prevailing at the time of production, while real GDP measures the output produced in any
one period at the prices of some base year. The real GDP is calculates the real change in the level
of output after removing the influence of change in prices or inflation. In other word, nominal
GDP is calculated using changing prices, while real GDP represents the change in the volume of
total output after price changes are removed.

The countries could have their own base year prices. In Ethiopia, the Ministry of Finance and
Economic Development (MOFED) has changed the base year for estimation of real GDP to the
year 2010/2011 (2003 Ethiopian Financial year). According to MOFED, a more recent base year
is considered with a view to incorporate structural changes in economy.

27
To make the idea more clear lets consider one hypothetical country producing only three
products namely teff, soft drink, and machinery. The amounts of production and the prices of
two years are presented in the following table.

Production 2010/11 2011/12

Price Quantity Price Quantity

Teff 1000 100 1200 100

Soft drink 7 75 8 75

Machinery 2000 25 2500 25

The nominal GDP of each year can be computed by multiplying the amount produced with the price of
commodity prevailing at the time of production.

Nominal GDP ( t )=∑ Q¿ P¿

Nominal GDP(2010/11)=¿

Nominal GDP(2010/11)=( 1000)(100)+(7)(75)+(2000)(25)=150,525

Similarly, for 2011/12

Nominal GDP(2011/12)=¿

Nominal GDP(2011/12)=(1200)(100)+(8)(75)+(2500)(25)=183,100

Taking these values of nominal GDP it is possible to estimate the growth rate between 2010/11 and
2011/12. For this purpose the following formula can be applied.

nominal GDP ( t )−nominal GDP ( t−1 )

Growt h rate of GDP ( t )= (100)
nominal GDP ( t−1 )

nominal GDP (2011/12)−nominal (2010 /11)

Grow t h rate of GDP= x 100
nominal GDP( 2010/11)

183 , 100−150 ,525

Growt h rate of GDP= x 100=21.64
150 , 525

But if we compare the level of outputs for three items, all have equal amount of output. It clearly indicates
that use of nominal GDP for comparative analysis is usually misleading. Applying a certain constant price
in different time horizon solves the problem of change in price. Using the price of 2010/11 for both years,
the GDP of two years would be identical.
28
Real GDP (2010/11)=(price of teffin 2010 /11)(quantity of teffin2011/12)+(price of soft drink ∈2010/11)(quant

Real GDP (2010/11)=(1000)(100)+(7)(75)+(2000)(25)=150,525

Similarly, for 2011/12

Real GDP (2011/12)=( price of teff 2010/11)(quantity of teffin2011/12)+(price of soft drink 2010/11)(quantity o

Real GDP (2010/11)=(1000)(100)+(7)(75)+(2000)(25)=150,525

Now, if we make comparisons of the GDP of 2010/11 with 2011/12, the GDP grew at 0 percent, which is
logically true.

Real GDP ( t ) −Real GDP ( t−1 )

Growt h rate of GDP ( t )= (100)
Real GDP ( t−1 )

Real GDP (2011/12 )−Real GDP ( 2010 /11 )

Growt h rate of GDP ( 2011/12 ) = ( 100)
Real GDP ( 2010/11 )

150525−150525
Growt h rate of GDP ( 2011/12 ) = (100)
150525

Growt h rate of GDP ( 2011/12 ) =0 percent

In the presence of inflation, the nominal GDP may overestimate value of physical output during the year.
In this case, Real GDP resolves overestimation, since it uses a constant market price of the base year. In
other word, Real GDP resolves the problem of overestimation by eliminating the change in the price level
from the nominal GDP. Thus, real GDP is comparatively appropriate measure of the rate of economic
growth relative to nominal GDP.

2.5 Limitation of GDP as Indicator of Economic Welfare

GDP is a reasonably accurate and extremely useful measure of domestic economic performance.
It is not and was never intended to be, an index of social welfare. GDP is simply a measure of the
annual volume of market oriented activity.

Nevertheless, it is widely held that there should be a strong positive correlation between real
GDP and social Welfare, that is, greater production should move society towards “the good life”.
GDP includes many questionable entries and omits of many valuable economic activities. Thus,
we must understand some of the short coming of GDP. Let us consider major points.

29
i. Exclusion of non-market transaction: recall that the standard accounts only include
primarily market activities. But much useful economc activities take place. For
example, many household activities produce valuable “near-market” goods and
services such as meals, laundering, and child-care services. Because GDP calculation
excludes the values of such no-market transactions, it causes GDP to be
underestimated.
ii. Omitted Leisure time: the value of leisure time (i.e. shorter working day or week) is
omitted for the GDP. On average, many Ethiopian want spend as much of their time
on utility-producing leisure activities as they do on money-producing work activities.
Yet the value of leisure time is excluded from our official national statistics of GDP.
iii. Exclusion of underground economy: You might wonder about the many activities in
the underground economy, which covers a wide variety of market activities that are
not reported to the government. It includes a wide variety of activities like gambling,
prostitution, drug dealing, work done by illegal immigrants, under invoice of import
and export, street vending, smuggling, and so on. Actually, much of underground
activity is intentionally excluded because the national output excludes illegal
activities-these are by social consensus “bads” and not “goods.” Thus, the existence
of this economy in the country causes the under estimation of GDP for the reason that
the traditional method of calculating GDP fails to include goods and services
produced in the underground economy.
iv. Omitted environmental damage: in addition to omitting activities, sometimes GDP
omits some of the harmful side effects of economic activity. An important example is
the omission of environmental damages. When industrial firms growing, GDP of a
country might increase. However, GDP ignores the negative externalities that follow
due to industrial expansion on the neighborhood with air pollution in the process of
production.. Among others, the negative externalities include noise, liquid and solid
wastes, and so on. The exclusion of negative externalities may lead to overestimated
GDP.
v. Improved product quality: GDP is a quantity, and not a qualitative measure. It does
not accurately reflect the improvement in product quality. For example, there is a
fundamental qualitative difference between a personal computer purchased today and
a computer that bought just a few years ago. Failure to account for such quality
30
 improvement is a sort coming of GDP accounting. Quality improvement clearly
affects the economic well-being as much does the quantity of goods. Because product
quality improved over time, GDP understates improvement in material well-being.
vi. Ignore composition and distribution of output: change in composition of goods and
services and how output is distributed among the members of society affects
economic welfare. But GDP does not specify which goods and services are produced
as well as for whom it is distributed. GDP only inform the birr value of the produced
goods and services.

2.6 Measuring Inflation (Cost of Living)

The GDP Deflator and the Consumer Price Index

From nominal GDP and real GDP we can compute a third statistic: the GDP deflator. The GDP
deflator, also called the implicit price deflator for GDP, is defined as the ratio of nominal GDP to
real GDP:

Nominal GDP
GDP Deflator= .
Real GDP

The GDP deflator reflects what’s happening to the overall level of prices in the economy. To
better understand this, consider an economy with only one good, bread. If P is the price of bread
and Q is the quantity sold, and then nominal GDP is the total number of dollars spent on bread in
that year, P × Q. Real GDP is the number of loaves of bread produced in that year times the price
of bread in some base year, P base × Q. The GDP deflator is the price of bread in that year
relative to the price of bread in the base year, P/P base. Thus, GDP Deflator measures price of a
current year relative to price of a base year.

To make the idea more clear let consider the previous example of a hypothetical country
producing only teff, soft drink, and machinery. Under the previous discussion we have computed
both the nominal and real GDP as summarized in the form of table as below.

Years Nominal GDP Real GDP

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

Using these computed values of nominal GDP and real GDP we can compute the GDP Deflator for each
year.

Nominal GDP(2010/11)
GDP Deflator (2010/ 11) =
Real GDP(2010/11)

31
 150,525
GDP Deflator (2010/ 11) = =1
150,525

This result implies that at the base year, both nominal and Real GDP are equal and the GDP Deflator
always equal to 1 (or 100 in terms of percentage).

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

Nominal GDP(2011/ 12)

GDP Deflator (2011 /12)=
Real GDP(2011/ 12)

183,100
GDP Deflator (2011 /12)= =1.2164
150,525

This result implies that the price in 2011/12 is 21.64 percent ((1.2164-1)*100) relatively higher than that
of 2010/11. It can be formally computed as below.

GDP Deflator (2011 /12)−GDP Deflator (2010/11)

Inflation rate= ∗100
GDP Deflator(2010/11)

1.2164−1
Inflation rate=( )(100)
1

Inflation rate=(0.2164)(100)

Inflation rate=21.64 percent

From this example it is possible to understand that GDP Deflator as a measure for the price change (or
inflation). The GDP deflator allows us to separate nominal GDP into two parts: one part measures
quantities (real GDP) and the other measures prices (the GDP deflator). That is,

Nominal GDP = Real GDP × GDP Deflator

We can also rewrite this equation as

Nominal GDP
Real GDP= .
GDP Deflator

In this form, you can see how the deflator earns its name: it is used to deflate (that is, take inflation out of)
nominal GDP to yield real GDP.

The Consumer Price Index, CPI

The Consumer Price Index (CPI) is probably the most commonly cited index of price. Just as
GDP turns the quantities of many goods and services into a single number measuring the value

32
of production, the CPI turns the prices of many goods and services into a single index measuring
the overall level of prices.

CPI measures the price of a representative basket called CPI-basket of goods that purchased by
consumers. It is used to compare what a fixed basket of goods costs this month with what it cost
in some reference base period. The CPI-basket contains basically all the goods and services
consumed in a country like food, gas, haircuts, transportation, house rent and so on. The
composition of the CPI-basket is determined by the value of what is consumed in the country-
the larger the value of total consumption of a good or service, the larger the weight in the basket.
For example, if we spend three times as much on food as on house, food will have three times
weight in the CPI-basket. Thus, the weights reflect the importance of each good in the typical
consumer’s budget.

The exact details of the composition of the basket and how the CPI is calculated are complicated
and vary somewhat between countries. In Ethiopia, Central Statistical Authority (CSA) has a job
of computing the CPI. The CSA calculate and report once a month. The CSA determines the
market basket that used for CPI calculation from periodic Consumer Expenditure Surveys, which
are used to update the weighting scheme about once in every five years. The recent compositions
and weights of items in the market basket are presented as in the following table. (reference
period: 2010/11 (2003 E.C.))

Content of Market Basket Weight in percent

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

How should economists aggregate the many prices in the economy into a single index that reliably
measures the price level? The CPI calculation has three steps:
33
 i. Finding the cost of CPI-basket at the base period prices.
ii. Finding the cost of CPI-basket at current period prices.
iii. Calculating the CPI for the base period and the current period.

The next example shows a simplified CPI calculation in which we assume a base period of 2010/11.

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

Item Quantity Base-year price Subsequent-year price

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

CPI-market basket Cost of

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

CPI-market basket Cost of

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

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

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

Alternatively, we can use the weighting approach to compute CPI. This the often applied approach to
measure the CPI once we have weight for each item in the CPI-basket. In this case we need to apply the
formula.
n
Pi Ei
CPI =∑
i=1 Pbase (i) E base

Where Pi current price of consumer good (i)

Pbase (i) base year price of good (i)

Ei base year expenditure on good (i)

34
 Ebase base year total expenditure

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

For 2010/11, the CPI is:

1000 100,000 7 525 2000 50,000

¿( )( )+ ( )+ ( )
1000 150,525 7 150,525 2000 150,525

¿ 1 ( 0.6643 ) +1 ( 0.0035 ) +1 ( 0.3322 )

CPI =1

For 2011/12, the CPI is:

1200 100,000 8 525 2500 50,000

¿( )( )+ ( )+ ( )
1000 150,525 7 150,525 2000 150,525

¿ 1.2(0.6643)+1.14 (0.0035)+ 1.25(0.3322)

¿ 0.7972+0.0040+ 0.4152

¿ 1.2164

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

CPI t −CPI t −1
π= (100 )
CPI t −1

1.2164−1
π= ( 100 )
1

π=0.2164 ( 100 )

π=21.64 %

But usually CPI give somewhat different information about what’s happening to the overall level of
prices in the economy when compare with GDP deflator. There are three key differences between the two
measures of cost of living.

i. The first difference is that the GDP deflator measures the prices of all goods and services
produced, whereas the CPI measures the prices of only the goods and services bought by
consumers. Thus, an increase in the price of goods bought by firms or the government will
show up in the GDP deflator but not in the CPI.
ii. The second difference is that the GDP deflator includes only those goods produced
domestically. Imported goods are not part of GDP and do not show up in the GDP deflator.
Hence, an increase in the price of a Toyota made in Japan and sold in Ethiopia affects the
CPI, because consumers buy the Toyota, but it does not affect the GDP deflator.

35
 iii. The third and most subtle difference results from the way the two measures aggregate the
many prices in the economy. The CPI assigns fixed weights to the prices of different goods,
whereas the GDP deflator assigns changing weights. In other words, the CPI is computed
using a fixed basket of goods, whereas the GDP deflator allows the basket of goods to change
over time as the composition of GDP changes.

In recent years there has been considerable discussion that implies that the CPI overstates the “true”
increase in the cost of living. Since some components living are not measured exactly, the CPI does
not measure the cost of living accurately. In this case the CPI is possibly a biased measure of cost of
living. The bias arise due to four potential sources, namely, new goods bias, quality change bias,
commodity substitution bias, and outlet substitution bias.

i. New Goods Bias: new goods do a better than old goods that they replace, but cost more. This
arrival of new goods puts an upward bias into the CPI and its measure of the inflation rate.
ii. Quality change bias: better cars and televisions cost more than the versions they replace. A
price rise is a payment for improved quality and it is not for inflation but might get measured
as inflation.
iii. Commodity substitution bias: if the price beef raises faster that the price of chicken, people
buys more chicken and less beef. But the CPI-basket does not change to allow for the effects
of substitution between goods.
iv. Outlet substitution bias: if the prices rise more rapidly, people use discount stores more
frequently. But the CPI basket does not change to allow for the effects of outlet substitution.

As a possible solution this can be reduced by deciding on how to increase the frequency of Consumer
Expenditure survey and the subsequent revision on the CPI- basket. If this is not possible the bias has two
main negative consequences on private contacts and government outlays and taxes.

i. Distortion of private contacts: many wage contacts are linked to the CPI. If the CPI is biased,
these contracts might deliver an outcome different from that intended by the parties. Suppose
that WU sign a 3 years wage deal: in the first year, the wage will be 30 birr an hour and will
rise by the assumed inflation rate in the next two years. If the assumed inflation rate is 5
percent a year, the age rises to 31.50 birr an hour in the second year and 33.08birr an hour in
the third year. But if the actual inflation rate is 2 percent a year, the intended wages in the
second and third years are 30.9 birr an hour and 31.83 birr an hour. Here, what the workers’
gain is the loss for WU. With hundredth of workers, WU’s loss would be millions of birrs
over the three years period.
ii. Increases in the government outlays and decreases in the taxes: major portion of the federal
government outlays are linked directly to the CPI. The CPI is used to adjust social security
benefit payments, pension payments (for retired military personnel, federal civil servants, and
their spouses), budget for school lunches, and others.
The CPI is also used to adjust the income levels at which higher tax rates apply. Because tax
rates on large incomes are higher than those on small incomes rise, the burden of taxes would
rise relentlessly if these adjustments were not made. To extent that the CPI is biased upward,
the tax adjustments over-compensate for rising prices and decrease the amount paid in taxes.

36
 Required reading:
Students are advised to read on alternative measures of the price level “Producer Price Index
(PPI)” and “Personal Consumption Expenditures Deflator (PCE deflator)”

2.7 Measuring Joblessness: The Unemployment Rate

One aspect of economic performance is how well an economy uses its resources. Because an
economy’s workers are its chief resource, keeping workers employed is a paramount concern of
economic policymakers. The measurement of the level of national employment or
unemployment rate requires classification of the concepts like labour force, employed and
unemployed.

Labour force means the sum of the number of the population in the working age with jobs and
those who are actively seeking job and /or available for work but failed to find job. In other
word, labour force refers to the supply of labor available for the production of goods and services
in an economy. It excludes the adult population that is keeping house, retired, elderly, children,
too ill to work, simply not looking for work, or institutionalized individual (those in jail, military,
and those on education).

The total labour force is classified in to employed and unemployed. Employed are people who
perform paid work, as well as those who have jobs but are absent from work because of illness,
strikes, or vacations. Unemployed group includes people who are not employed but are actively
looking for work or waiting to return to work. To be counted as unemployed, a person must do
more than simply think about work. A person must report specific efforts to find a job (such as
having a job interview or sending a resumes). In other word, unemployed refers to those
involuntary unemployed.

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

rate, which is defined as the percentage of those in the labor force who are unemployed.
Unemployment rate is one of the important macroeconomic variables and the best single index to
explain the performance of the economy and the status of the labor market. The national
unemployment given the total labour force we have computes as:

Number of Unemployed
Unemployment Rate = ×100.
Labour Force

37
Where the Labor Fo rce=Number of Employed+ Number of Unemployed .

Numerical examples:

1. The statistical report on the 1999 national labour force survey indicated that 25,121,414 are
employed while the remaining 500,761 are
unemployed (CSA, 1999). Then find,
a. Total labour force
b. Unemployment rate

Solution

a. Labor Force=Number of Employed+ Number of Unemployed .

Labor Force=25,121,414+500,761=25,622,175
b. Unemploymen t Rate=
Number of Unemployed
×100
Labour Force
500,761
Unemployment Rate = ×100
25,622,175
Unemployment Rate =2 percent
2. During the same period (1999) the ratio of employed male to unemployed male was 67.219.
Given this ratio find the unemployment rate for male population.
Solution
Number of Unemployed
Unemployment Rate = ×100
Labour Force
N umber of Unemployed
Number of Unemployed
Unemployment Rate = × 100
number of employed +number of unemployed
number of unemployed
1
Unemployment Rate = × 100
number of employed
1+
number of unemployed
Now it is possible to substitute the above given ration.
1
Unemployment Rate = ×100
1+67.219

Unemployment Rate =1.466 percent

On the basis of their sources, there are various types of unemployment categories. The most
frequently stated types are demand deficient or cyclical, frictional, structural, and seasonal
unemployment. Still there are some additional types of unemployment that are occasionally
mentioned such as classical, hidden, and underemployment or disguised unemployment. Real-
world unemployment may combine different types. Thus, distinguishing clearly one from the
other and measuring the magnitude of each of them is difficult, partly because they overlap.

38
Cyclical/Demand deficient/Keynesian unemployment arises from the business cycle as a result
of insufficient effective aggregate demand. Obviously, this type of unemployment coincides with
unused industrial capacity and as traditional Keynesian economics suggests, it may possibly be
addressed by adopting either expansionary fiscal policy (deficit spending) or expansionary
monetary policy.

Frictional /Search unemployment is transitional or temporary unemployment that arises because

a person may take time to find a new job after losing or quitting a job, or after entering or
reentering the labor force following schooling, illness, or some other reason for being out of the
labor force. It usually occurs due to imperfect information in the labor market. It is common in
any economy and partially desirable as long as the switch from one job to another increases
individuals’ welfare and economic efficiency.

Structural unemployment is caused by a mismatch between the workers looking for jobs and the
vacancies available. It is attributed to changes in geographical location or skill variation or
industrial structure of the economy. On the other hand, Seasonal unemployment arises as
employment condition changes over the season of the year. It may be related to both supply side
and demand side seasonality.

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

problem because it represents waste of a valuable resource. When workers become unemployed,
the output of a nation decreases. The nation loses output which would be produced by
unemployed workers. When unemployment occurs, it’s immediate impact rest on unemployed
individuals. Consequently, a loss of job implies a loss of income and thus consumption of
unemployed individuals’ declines. Besides, due to high unemployment government lose tax
income and producers lose profit that would be generated form high level of production.

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

unemployed workers struggled with reduced level of their income. During the periods of high
unemployment, economic distress spills over to affect people’s emotions and family lives. While
the unemployed population increases, drug abuse, crime rate and related habit would be increase.
These create social problems.

2.8 Business Cycle and the Relationship between Macroeconomic Variables

39
Economists have always followed the periodic changes that occur in level of business activity.
These fluctuations are called business cycles. In this section, we will briefly define the term
business cycle and describe some of its phases.

In a free enterprise economy, plans and decisions are made independently by a large number of
economic agents. From time to time, imbalances between supply and demand will emerge and
agents will not always be able to make the necessary adjustments to remove the imbalance. The
inability to foresee and plan for all contingencies leads, on occasion, to an accumulation of
imbalances throughout the economy. Such aggregate fluctuations are called business cycles.

Business cycles are recurring changes in economic activity. They do not follow any fixed
periodic pattern such as seasonal cycles. Furthermore, each cyclical episode can differ with
respect to the duration, depth, and diffusion of the cycle.

Although each business cycle is unique, there are enough similarities to make some general
statements about the performance of the economy over the course of a typical cycle. Let us enter
the process with an economic expansion getting underway.

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

macroeconomic policy, foreign demand, underlying growth expectations, and the inherent forces
that bring a contraction to an end. The latter can include the influence of low mortgage interest
rates on housing demand. Furthermore, low interest rates and the ready availability of skilled
labor, plant capacity, material inputs and credit may lead entrepreneurs with underlying
confidence in the economy to seize the opportunity and start new projects. Such responses can go
a long way to starting an expansion phase.

The expansion impulse will spread quickly through the economy. Increases in earnings in the
expanding sectors will generally lead to increased retail sales throughout the economy. New
orders will expand in all sectors and bring the recession to an end. In the early phase of the
expansion, output can be increased with only small increases in employment. Thus, productivity
growth (the growth of output per labor hour) is likely to be rapid. As a consequence, profits are
likely to respond quickly.

As the expansion goes on, capacity constraints loom in the not-too-distant future and delivery
lags begin to lengthen. At the same time, interest costs and equipment prices are favorable. Thus,
40
contracts and orders for investment goods begin to rise, and, with some lags, investment
expenditures increase as well.

At this point, the expansion is well under way. GDP quickly surpasses its previous peak and a
mood of optimism spreads over the economy. There is a willingness to undertake new activities
and the expansion is self-reinforcing. Although there may be pauses in growth due to brief
inventory adjustments, the strength of consumer demand and investor confidence can maintain
an expansion for a long period of time.

Nevertheless, forces that can generate a recession do appear, and if a few of them come together,
the expansion can reach its peak. First, as the expansion eliminates all slack in the economy,
shortages of key resources might create physical barriers to further expansion. Second, as
capacity is reached, costs of production will go up, profit margins decline and productivity
growth slows. Growth expectations and the mood of optimism may begin to erode. Third, unless
the monetary authority accommodates all inflationary pressures, the expansion is likely to lead to
increased interest rates. Home building is often the first sector affected by interest rate pressures.
Fourth, a vigorous expansion may lead to a too rapid buildup of inventories and capital goods. At
this stage, the economy is perched precariously between a slowdown in the expansion and a
recession.

If the balance of contractionary forces grows, the economy will enter a recession. After the peak
of economic activity, many firms will find their inventories expanding rapidly as demand falls.
There are pressures on profits and many firms might be experiencing financial difficulties. Cash
flow might be insufficient to service debt incurred during the expansion and the number of
bankruptcies is likely to increase. Once the contraction is clearly underway, unemployment will
increase. The forces of recession will also be self-reinforcing.

However, there are a number of forces that make recessions rather short phases. First,
consumption and investment plans are to a large extent determined by long-run expectations.
Second, competitive pressures lead firms to take advantage of the recession to improve
efficiency and increase market share. Third, the depreciation of capital leads to new investment
demand. Finally, policy-makers are likely to take action to shorten a recession and this drives
expectations. Thus, most recessions come to an end within a year and before the toll of
unemployment has a major impact on the well-being of society.
41
Growth rate peak peak growth trend

Peak

Expansion contraction contraction

Contraction Trough

Trough expansion Time

This diagram shows a long-term growth (secular) trend that is substantially positive (the straight, upward
sloping line). About that secular trend is another curved line, whose slope varies between positive and
negative, this is much the same as the business cycle variations about that long-term growth trend.

In general, a business cycle shows more or less regular pattern of expansion (recovery), contraction
(recession, and intermediate phases of peak as well as trough. (see simplified diagram of business cycle
below)

SUMMARY

1. GDP is the most comprehensive measure of the output of all the factories, offices, and shops in a
given country. It is the market value of all final goods and services produced within an economy in a
given period of time. Alternatively Gross National Product (GNP) is the value of all final goods and
services that produced by citizens of a country during a specific period, usually one year, irrespective of
their place of residence.

2. Currently, there are three alternative approaches to calculate the GDP in the economy namely
expenditure, income and output (value added) approaches. All the approaches give identical results.
Expenditure approach determines GDP through summing up of all types of spending on finished goods
and services by four major economic agents (households, businessmen, government, and foreign sector.

3. Income approach involves calculation of GDP by summing up all incomes that derived from the
production process. In other words, it includes all payments made in respect of the four factors of
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production, namely labor, capital, land and entrepreneurship over a given period of time. This implies that
the total of all wages and salaries, interest, rent and profits is conceptually equal to the GDP as calculated
according to the expenditure method.

4. Output (value added) approach measure GDP as the sum of the net value (value added) of the
output produced by all firms in the economy. This approach measures GDP in terms of values added by
each sector of economy.

5. Economists evaluate the success of an economy’s overall performance by how well it attains
these objectives: (a) high level and rapid growth of output and consumption; (b) low unemployment rate
and high employment, with an ample supply of good jobs; (c) price-level stability (or low inflation).

6. Today, there are numerous instruments through which the government can steer the economy: (a)
Fiscal policy (government spending and taxation) helps determine the allocation of resources between
private and collective goods, affects people income and consumption, and provides incentives for
investment and other economic decisions. (b) Monetary policy (particularly central-bank regulation of the
money supply to influence interest rates and credit conditions) affects sectors in the economy that are
interest-sensitive.

7. The easiest case, in macroeconomic equilibrium, is the one assumed by classical economists: a
quick clearing of all markets and perfect foresight. In that case, monetary policy is neutral in the sense
that it cannot affect the real wage, employment, or output, neither in the short run nor in the long run. A
doubling of the money supply simply leads to a doubling of the aggregate price level. A fiscal expansion
is fully crowded out by a fall in private investment (and net exports) on account of a rise in the interest
rate (and an appreciation of the currency), so that neither employment nor output is affected. Hence, only
supply-side policies, such as changes in the capital stock or in the various tax rates, can affect
employment and output.

8. Modern day versions of the classical economists are the new classical, also called the "fresh
water" economists, who stress rational expectations in stochastic environments and microeconomic
foundations of macroeconomic relationships.

9. A related breed of macroeconomists are the supply siders who believe in cutting taxes as this
would boost tax revenue and alleviate the need to cut public spending. The supply siders were very
influential in the 1980s, but have largely been discredited.

10. The older variety of Keynesian economists assumed sticky prices in the short run, so that
employment and output were mainly determined by aggregate demand in the short run. A recent school of
new Keynesians give the microeconomic underpinnings by stressing imperfect competition, coordination
failures, and credit restrictions.

11. The neo-Keynesian synthesis allows for a Keynesian short run and classical long run by
introducing the assumption of adaptive expectations regarding the price level. In the short run the
multiplier associated with a fiscal expansion is further reduced due to the rise in the price level. This leads
to a contraction in real money balances, a further rise in the interest rate, and thus a dampening of the
expansion in aggregate demand. Over time households revise their expectations upwards. As a result,
aggregate supply and employment fall until the original equilibrium is restored again. The long-run output

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and employment multipliers for a rise in government spending are thus zero because any expansion of
aggregate demand is fully offset by reductions in private investment (and net exports) caused by a higher
interest rate (and appreciation of the currency).

12. Monetarists are somewhere in between the classical and Keynesian economists. They allow for
adaptive expectations, but believe in the ineffectiveness of fiscal policy and the potential harmfulness of
using monetary policy to manage aggregate demand. Monetarists believe in long and variable lags in
monetary policy and therefore advocate a constant and modest rate of monetary growth. Clearly,
monetarists are also deeply suspicious of using fiscal policy to fight unemployment.

FURTHER READING:

 Ben J.Heijdra, & Frederick van der Ploeg (2002) Foundation of Modern Macroeconomics,
Oxford University Press, New York.
 Henock Adamu (2013) Principles of Economics: Introductory Theories, printed by Far East
Trading, Addis Ababa, Ethiopia.
 Mankiw, N.G. (2007) Macroeconomics, 4th edn,
 Saumuelson, P.A, (2006) Economics, 18th edn., Tata McGraw-Hill Publishing Company
Limited, New Delhi.

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