Chapter Two

National Income accountingChapter TwoHow do we know how well the economy is doing?Economists collect statistics on production, income, investment, and savings.

This is called national income accounting.

The most important measure of growth is GDP.

What is GDP? It is the nations expenditure on all the final goods and services produced during the year at market prices.

An alternate definition:GDP is the value of all the final goods and services produced within a nations boundaries during the year. This would include the wages, rent, interest, and profits earned by foreigners who work in the Ethiopia.

We include only those goods and services that consumers, businesses, and governments buy for their own use.

What does GDP tell us?

Just like calculating your own income, GDP measures how well the Ethiopian economy is doing financially.

Both goods, such as automobiles and top hats, and services, such as the help of lawyers and plumbers, are included.

Current market prices, reflecting the value society places on items, are used to aggregate different outputs to a dollar total.

Government purchases, many of which do not occur on markets, are valued at their cost of production.

Only final goods and services are included-anything that is directly sold to the consumer.

Intermediate goods, such as steel that has yet to be made into hammers and shovels, are not included. This practice avoids double-counting the steel.This measure is an annual flow, a rate of production.

Finally, GDP is a flow variable not a stock.

GDP, being a flow, is not a measure of the total wealth of a country but a measure of the income "of the country during a certain period of time.

Ethiopian GDP measures production by Ethiopian citizens and foreigners alike inside the geographic borders of Ethiopia and so unequivocally reflects economic activity in Ethiopia.

Economists and the media use many names besides GDP to refer to the nation's annual output of goods and services.

Output, total output, national output, income, total income, national income, and aggregate supply are common.

Algebraic representations use the capital letter Y.

These names suggest that economists use the terminology output and income interchangeably; it is important to understand why.

The essence of why output and income are considered the same thing is that whatever is spent on a product (the value of that output) is divided up as income by those people producing it.

Consider one element of GDP, a loaf of bread worth a dollar.

With only a few exceptions, every penny of this dollar's worth of bread can be traced back into somebody's pocket as incomeSome of the dollar is

profit/proprietor income to the grocer, baker, miller, and farmer (or dividend income to their stockholders),

some is wage and salary income to their employees,

some is interest income to the banker who has financed their loans (or interest income to those who purchased their corporate bonds), and

some is rental income to their landlords.

It is because of this equivalence that total output, GDP, is referred to as total income.

GDP and GNPGNP is the value of all final goods and services produced by domestically owned factors of production within a given period.

The difference between GDP and GNP arise due the fact that some of the goods and services produced within a given country is made by factors of production owned by abroad.

The difference between GDP and GNP correspond to the net income earned by foreigners.

When GDP exceed GNP, residents of a given country are earning less abroad than foreigners are earning in that country.

Income, Expenditure, and the Circular FlowImagine an economy that produces a single good, bread, from a single input, labor.

The inner loop tells us the flow of bread and labor.

The households sell their labor to the firms.The firms use the labor of their workers to produce bread, which the firms in turn sell to the households.

The outer loop represents the corresponding flow of birr.The households buy bread from the firms.The firms use some of the revenue from these sales to pay the wages of their workers, and the remainder is the profit belonging to the owners of the firms (who themselves are part of the household sector).

Hence, expenditure on bread flows from households to firms, and income in the form of wages and profit flows from firms to households.

GDP measures the flow of birr in this economy. We can compute it in two ways.

GDP is the total income from the production of bread, which equals the sum of wages and profitthe top half of the circular flow of birr.

GDP is also the total expenditure on purchases of breadthe bottom half of the circular flow of birr.

To compute GDP, we can look at either the flow of birr from firms to households or the flow of birr from households to firms.

These two ways of computing GDP must be equal because the expenditure of buyers on products is, by the rules of accounting, income to the sellers of those products.Rules for Computing GDPAdding different goods and servicesBecause different products have different values,

GDP combines the value of these goods and services into a single measure using market price.

Used GoodsGDP measures the value of currently produced goods and services.

The sale of used goods reflects the transfer of an asset, not an addition to the economys income.

Thus, the sale of used goods is not included as part of GDP.The Treatment of Inventories

Imagine that a bakery hires workers to produce more bread, pays their wages, and then fails to sell the additional bread.

How does this transaction affect GDP?Lets first suppose that the bread spoilsIn this case, the firm has paid more in wages but has not received any additional revenue, so the firms profit is reduced by the amount that wages are increased.

Total expenditure in the economy hasnt changed because no one buys the bread. Total income hasnt changed eitheralthough more is distributed as wages and less as profit.

Because the transaction affects neither expenditure nor income, it does not alter GDP.

Now suppose, instead, that the bread is put into inventory to be sold later

In this case, the transaction is treated differently.

The owners of the firm are assumed to have purchased the bread for the firms inventory, and the firms profit is not reduced by the additional wages it has paid.

Because the higher wages raise total income, and greater spending on inventory raises total expenditure, the economys GDP rises.

What happens later when the firm sells the bread out of inventory?This case is much like the sale of a used good.

There is spending by bread consumers, but there is inventory disinvestment by the firm.

This negative spending by the firm offsets the positive spending by consumers, so the sale out of inventory does not affect GDP.Intermediate Goods and Value Added

To add the intermediate goods to the final goods would be double counting.One way to compute the value of all final goods and services is to sum the value added at each stage of production.

The value added of a firm equals the value of the firms output less the value of the intermediate goods that the firm purchases.

For the economy as a whole, the sum of all value added must equal the value of all final goods and services.

Hence, GDP is also the total value added of all firms in the economy.Housing Services and Other ImputationsSome goods and services are not sold in the marketplace and therefore do not have market prices.

Thus, we must use an estimate of their value. Such an estimate is called an imputed value.

Eg. The estimated value of what the market rent for a house would be if it were rented and it will be included as part of GDP.

For those government services provided to the general public, since they are not sold in the market valuation is difficult.

The cost of providing these services will be included as part of GDP.

In many cases, an imputation is called for in principle but, to keep things simple, is not made in practice. It is difficult to incorporate the inputted value of all goods owned and used by the owner.

Some of the output of the economy is produced and consumed at home and never enters the marketplace.

Finally, no imputation is made for the value of goods and services sold in the underground economy.

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.

Because the imputations necessary for computing GDP are only approximate, and because the value of many goods and services is left out altogether, 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.

Yet as long as the magnitude of these imperfections remains fairly constant over time, GDP is useful for comparing economic activity from year to year.

Real GDP Versus Nominal GDPIs GDP a good measure of economic well-being?GDP is the value of all final goods and services produced. Nominal GDP measures these values using current prices. Real GDP measure these values using the prices of a base yearReal Vs. Nominal GDP

Compute nominal GDP in each year. Compute real GDP in each year using 2005 as the base year.200520062007PQPQPQGood ABirr 30900Birr 311000Birr 361050Good BBirr 100192Birr 102200100205Real GDP controls for inflation Changes in nominal GDP can be due to:Changes in prices Changes in quantities of output produced

Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices

Because a societys ability to provide economic satisfaction for its members ultimately depends on the quantities of goods and services produced,

Real GDP provides a better measure of economic well-being than nominal GDP.

The GDP DeflatorInflation rate: the percentage increase in the overall level of prices One measure of the price level: GDP deflatorGDP Deflator = 100*(Nominal GDP/Real GDP)The GDP deflator reflects whats happening to the overall level of prices in the economy.

Use your previous answers to compute the GDP deflator in each year. Use GDP deflator to compute the inflation rate from 2005 to 2006, and from 2006 to 2007.

NGDPRGDPGDP deflatorInflation rate2005Birr 46,200Birr 46,200?n.a2006Birr 51,400Birr 50,00??2007Birr 58,300Birr 52,000??Chain-Weighted Real GDP Over time, relative prices change, so the base year should be updated periodically. The chain-weighted real GDP updates the base year every year, so it is more accurate than constant-price GDP .Consumer Price Index (CPI) A measure of the overall level of prices Published by the Central Statistics Agency (CSA) Uses: Tracks changes in the typical households cost of livingadjusts many contracts for inflation (COLAs)allows comparisons of dollar amounts over timeHow the CSA constructs the CPI1. Survey consumers to determine composition of the typical consumers basket of goods2. Every month, collect data on prices of all items in the basket; compute cost of basket3. CPI in any month equals Compute CPIBasket: 20 pizza, 10 CDsPrices:PizzaCDs2005Birr 10Birr 152006Birr 11Birr 152007Birr 12Birr 162008Birr 13Birr 15100* Cost of basket in that monthCost of basket in base periodFor each year, compute the cost of the basket the CPI (use 2005as the base year) the inflation rate from the preceding yearWhy the CPI may overstate inflation Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers ability to substitute toward goods whose relative prices have fallen.

Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the dollar.

But it does not reduce the CPI, because the CPI uses fixed weights.

Unmeasured changes in quality:

Quality improvements increase the value of the dollar but are often not fully measured.CPI vs. GDP DeflatorPrices of capital goods:included in GDP deflator (if produced domestically)excluded from CPIPrices of imported consumer goods:included in CPIexcluded from GDP deflatorThe basket of goods:CPI: fixedGDP deflator: changes every yearThe expenditure components of GDP Consumption, CInvestment, IGovernment spending, G Net exports, NXAn important identity:

Consumption (C)The value of all goods and services bought by households. Includes:Durable goods : last a long time e.g., cars, home appliancesNondurable goods: last a short time e.g., food, clothingServices: intangible items purchased by consumers e.g., dry cleaning, air travel

Value of total outputAggregate expenditureY = C + I + G + NXInvestment (I)Spending on capital, a physical asset used in future production .Includes:Business fixed investment: Spending on plant and equipmentResidential fixed investment: Spending by consumers on housing Inventory investment: The change in the value of all firms inventoriesGovernment spending (G)G includes all government spending on goods and services.G excludes transfer payments (e.g., unemployment insurance payments), because they do not represent spending on goods and services.

Net exports (NX)NX = exports imports Exports: the value of goods and services sold to other countries Imports: the value of goods and services purchased from other countries Hence, NX equals net spending from abroad on our goods and services

Other Measures of IncomeGNP =GDP +Factor Payments From Abroad Factor Payments to Abroad.

To obtain net national product (NNP), we subtract the depreciation of capitalthe amount of the economys stock of plants, equipment, and residential structures that wears out during the year:

NNP =GNP Depreciation

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

The next adjustment in the national income accounts is for indirect business taxes, such as sales taxes.These taxes place a wedge between the price that consumers pay for a good and the price that firms receive.

Because firms never receive this tax wedge, it is not part of their income.

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

National Income =NNP Indirect Business Taxes.

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

The five categories national income are:-Compensation of employees :The wages and fringe benefits earned by workers.

Proprietors income : The income of non corporate businesses, such as small farms, mom-and-pop stores, and law partnerships.

Rental income: The income that landlords receive, including the imputed rent that homeowners pay to themselves, less expenses, such as depreciation.

Corporate profits :The income of corporations after payments to their workers and creditors.

Net interest: The interest domestic businesses pay minus the interest they receive, plus interest earned from foreigners.Personal income, the amount of income that households and non corporate businesses receive.Personal Income =National IncomeCorporate ProfitsSocial Insurance ContributionsNet Interest+Dividends+Government Transfers to Individuals+Personal Interest Income.Next, if we subtract personal tax payments and certain nontax payments to the government (such as parking tickets), we obtain disposable personal income:

Disposable Personal Income=Personal Income Personal Tax and Nontax Payments.The Business Cycle and the Output GapInflation, growth, and unemployment are related through the business cycle. The business cycle is the more or less regular pattern of expansion (recovery) and contraction (recession) in economic activity around the path of trend growth.

At a cyclical peak, economic activity is high relative to trend; and

At a cyclical trough, the low point in economic activity is reached. Inflation, growth, and unemployment all have clear cyclical patterns.

The trend path of GDP is the path GDP would take if factors of production were fully employed. Over time, real GDP changes for the two reasons.

First, more resources become available which allows the economy to produce more goods and services, resulting in a rising trend level of output.

Thus, output can be increased by increasing capacity utilization. Output is not always at its trend level, that is, the level corresponding to full employment of the factors of production.Rather output fluctuates around the trend level. During expansion (or recovery) the employment of factors of production increased, and that is a source of increased production. Conversely, during a recession unemployment increases and less output is produced than can in fact be produced with the existing resources and technology. 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.

Output gap potential output actual output

When looking at the business cycle fluctuation, one question that naturally arises is whether expansions give way inevitably to old age, or whether they are instead brought to an end by policy mistakes.

Often a long expansion reduces unemployment too much; causes inflationary pressures, and therefore triggers policies to fight inflation- and such policies usually create recessions.

Okuns LawA relationship between real growth and changes in the unemployment rate is known as Okuns law, Named after its discoverer, Arthur Okun. Okuns law says that the unemployment rate declines when growth is above the trend rate.

Inflation Unemployment Dynamics: The Phillips CurveThe Phillips curve describes the empirical relationship between inflation and unemployment: the higher the rate of unemployment, the lower the rate of inflation. The curve suggests that less unemployment can always be attained by incurring more inflation and that the inflation rate can always be reduced by incurring the costs of more unemployment. In other words the curve suggests there is a trade-off between inflation and unemployment.

The End