Chapter II: NATIONAL INCOME

ACCOUNTING (NIA)

 Basic Concepts: GDP and GNP

 Approaches to Measurement of GDP

 Other Social Accounting

 Nominal Vs Real GDP

 The GDP Deflator and the Consumer Price Index

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2.1 Basic Concepts: GDP and GNP
NIA is the method of measuring the aggregate output and
income of an economy. It is based on the principle of the
circular flow of economic activity. The value of total output
equals the value of total income and expenditures.

Two of the most important measure of the overall economy’s

performance are GDP and GNP

Gross Domestic Product (GDP): is the market value of all

final goods and services produced in the economy, in a
given time period, and within the boundary of a country.

GDP is the value of final output produced by factors of

production located within a country whoever has produced it.
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In the calculation of GDP, intermediate goods are
excluded to avoid double counting.

Intermediate goods are goods that are produced by

one firm for use in further processing by another firm.
Eg. Stages of Production Values of Sales
Wheat 3.00
Flour 3.50
Bread 5.00

GDP = [Market Value of all products] – [Market Value of

intermediate products]
GDP = 11.50 – 6.50 = 5.00
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Rules for Computing GDP:
1. To compute the total value of different goods and services,
the national income account use market prices;
2. Second hand sales are not included in the calculation of
GDP. GDP 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 economy’s income.
3. Treatment of inventories depends on if the goods are safely
stored or if they spoil.
4. Intermediate goods are not counted in GDP – only the
values of final goods are included to avoid double-counting.
5. Some goods are not sold in the marketplace and therefore
do not have market prices.
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Gross National Product (GNP): is the monetary
value of all final goods and services produced by
resources owned and supplied by the country’s
citizen irrespective of where the resources are
located.

GNP measures the total income earned by all

resources of a nation.

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2.2 Approaches to Measuring GDP

The total output of a country can be measured in

three different ways:

1. The Value Added Approach

2. The Income Approach

3. The Expenditure Approach

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A. The Value Added Approach
The total value added of a country is the difference
between the monetary value of all outputs products and
the monetary value of all intermediate inputs i.e.
GDP = Value added = (Total output Value) – (Total intermediate Output Value)

Example
Value Value Added
Wheat 3.00 3.00
Flour 3.50 0.50
Bread 5.00 1.50
GDP = 5.00

B. Expenditure Approach
It is the sum of all expenditures on final goods and services.
The expenditures can be:
− Personal Consumption Expenditure (C), − Government Expenditure (G),
− Private Investment Expenditure (I), and − Net Exports ( X – M)
GNP = C + I + G + (X – M)
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C. Income Approach
It measures GDP in terms of income earned. It is the
sum of all incomes accrued to factors of production that
contribute to the production process.

It is the sum of all incomes received from all factors of

production which contribute to the production process
plus two additional non-factor payments.

The major components of a country’s income include:

Wage and salary (W + S) = it is compensation for employees
Rental income (R) = income payments received by households and
businesses from property resources (land, mineral rights, and building).

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Net interest (i) = return for capital – the interest domestic
businesses pay to hhs minus the interest they receive, plus net
interest earned from foreigners. Hhs receive net interest
payments on saving deposits, certificate of deposits (CDs),
corporate bonds, etc.

Profit (π) = income earned by entrepreneurs (proprietors &

corporates).

Depreciation (D) = the wear out of capital goods in the production

process.

Indirect business taxes (IBT) = business firms treat them as cost

of production and therefore add to the prices of the products they
sell and pay to the government. E.g. Sales tax, excise tax,
business property tax & license fee

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Depreciation and indirect business taxes are part of the
incomes of owners of factors of production and GDP is
therefore equal to

GDP = (W + S) + R + i + π + IBT + D

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2.3 Other Social Accounts

The national income accounts include other measures of

income that differ slightly in definition from GDP.

To see how the alternative measures of income related

to one another, we start with GDP and add or subtract
various quantities.

To obtain gross national product (GNP), we add receipts

of factor income (wages, profit, and rent) from the rest of
the world and subtract payments of factor income to the
rest of the world:
GNP = GDP + NFI
NFI = (Factor Income received from abroad) - (Factor income paid to abroad).
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GNP may be greater, equal, or less than GDP.
− If NFI > 0, then GNP > GDP − If NFI < 0, then GNP < GDP
− If NFI = 0, then GNP = GDP

In the production process, there is wear and tear of capital

goods, which is referred to as depreciation. It refers to the
value of the total output which is needed to replace worn
out capital.

Therefore, to obtain net domestic product (NDP) and/or

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:
Net Domestic Product (NDP) = GDP – depreciation
Net National Product (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.

The next adjustment in the national income accounts

is for indirect business taxes, such as sales, excise
and property taxes.

These taxes place a wedge between the price that

consumers pay for a good and the price that firms
receive.
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Because firms never receive this tax , it is not part of their
income. Once we subtract indirect business taxes from
NNP, we obtain a measure called National Income.

Therefore, national output is measured at market prices

including direct taxes.

National Income (NI) = NNP – IBT

Where IBT = indirect business taxes

National income is the total income earned by the factors

of production owned by citizens.

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It measures how much everyone (for instance, Ethiopian-
owned resources) in the economy has earned (got money
by working).

But it does not represent the total income received by

individuals (personal income).

Total income received by individuals is known as personal

income.

A series of adjustments takes us from national income to

personal income, the amount of income that households
and non-corporate businesses receive. Three
adjustments are most important:
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 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 (corporate taxes plus retained
earnings) and add dividends.

 Second, we increase national income by the net amount the

government pays out in transfer payments. This adjustment
equals government transfers to individuals minus social
insurance contributions paid to the government.

 Third, we adjust national income to include the interest that

households earn rather than the interest that businesses pay.
This adjustment is made by adding personal interest income
and subtracting net interest. (The difference between personal
interest and net interest arises in part from the interest on the
government debt.)
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PI = NI – (UCP + CYT) + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 + (TP – SSC) + 𝑃𝐼𝐼 - 𝑁𝑒𝑡 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Where UCP = Undistributed corporate profit
CYP = Corporate income tax
TP = Transfer payments (e.g.. subsidy = S)
SSC = Social security contribution
PII = 𝑃𝑒𝑟𝑠𝑜𝑛𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

Note: UCP + CYT + Dividends = Corporate Profit

Disposable personal income is the income individuals

have to spend or save after payment of taxes.

Personal disposable income

PDI = PI – PIT where : PIT = Personal income tax

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Therefore, the general trend of calculating the social
accounting is summarized as the following table:

GNP = GDP + NFI

NDP = GDP - depreciation
NNP = GNP - depreciation
NI = NDP/NNP – IBT
PI = NI - (UCP + CYT + SSC) + Dividends + TP + PII – (Net Interest)
PDI = PI - PIT

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 2.4 Nominal GDP Vs Real GDP
Since GDP is measured in monetary units (values), the
amount of GDP can change because of the changes in
quantity of goods and services produced and/or changes in
price of goods and services. However, we are usually
interested in the changes in the actual goods and services
produced, not because of prices. Therefore, there are two
types of GDP: Nominal and Real GDP.

a) Nominal GDP (GDP at Market Price): is simply the value

of final goods and services produced during the year
based on current market prices.
− *Nominal GDP can change when the amount of goods
and services produced change and/or when current
price changes.
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But the value of different years’ GDPs can be usefully
compared only if the value of money (price) itself doesn’t
change.

And, it is the quantity of goods & services produced and

distributed to households which affects their standard of
living, not the price.

Yet it would be misleading to say that the economy’s

ability to satisfy demands has doubled, because the
quantity of every good produced remains the same.

Thus, to compare GDPs of d/t periods (to see differences

in production activities or economic performance) nominal
GDP must be adjusted for price level changes.
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Since a society’s ability to provide economic
satisfaction for its members ultimately depends on the
quantities of goods & services produced, real GDP
provides a better measure of economic well-being than
nominal GDP.

A better measure of economic well-being would count

the economy’s output of goods and services and would
not be influenced by changes in prices.

Real GDP may be calculated using:

Base year fixed prices: real GDP is the value of goods and
services measured using a constant set of prices.
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Chain-weighted measures of GDP: over time the prices
would become more & more out dated. For instance, the
price of computers has fallen substantially in recent years,
while the price of a year at college has risen.
 When valuing the production of computers and education, it
would be misleading to use the prices that prevailed ten or
twenty years ago.

 To solve this problem, the base year changes continuously

over time.

 This new chain-weighted measure of real GDP is better than

the more traditional measure because it ensures that the
prices used to compute real GDP are never far out of date.

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b) Real GDP (GDP at Constant Price): is the measure of the
values of final goods and services by using price which is
prevailed during the base or reference year. Thus, real
GDP varies when the actual production of goods and
services change.

Nominal GDP Nominal GDP

Real GDP  
Price index GDP deflator
Example:
Total Output Price/Kg Nominal Real
Year Teff Wheat Teff Wheat T W GDP T W GDP
2002 70 30 2 1 140 30 170 140 30 170
2003 50 60 3 2 150 120 270 100 60 160
2004 100 60 2.5 3 250 180 430 200 60 260
Note: The base year is 2002.
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From the GDP and real GDP, we can compute a third
concept, the GDP deflator.

GDP Deflator: measures the current price of output

relative to its price in the base year.

It reflects what’s happening to the over all level of

prices in the economy.

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  X 100%
Real GDP
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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.

To better understand this, consider again an economy

with only one good, then nominal GDP is the total
number of dollars spent on bread in that year, PxQ.

Real GDP is the number of loaves of bread produced

in that year times the price of bread in some base
year, Pbase x Q. The GDP deflator is the price of bread
in that year relative to the price of bread in the base
year, P/Pbase.

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The definition of the GDP deflator allows us to
separate nominal GDP in to two parts: one part
measures quantities (real GDP) and the other
measures prices (the GDP deflator) that is,
Nominal GDP = Real GDP X GDP deflator.

To sum up, nominal GDP measures the current dollar

(money) value of the out put of the economy. Real
GDP measures out put valued at constant price; and
the GDP deflator measures the price of output relative
to its price in the base year.

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Consumer Price Index (CPI):
Measures the combined price of a particular collection
of goods & services in a specific period relative to the
combined price of an identical group of goods and
services in a reference period.

A dollar today doesn’t buy as much as it did 20 years

ago. The cost of almost everything has gone up.

This increase in the overall level of prices is called

inflation, and it is one of the primary concerns of
economists and policymakers.

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The most commonly used measure of the level of
prices (or of the cost of living) is the CPI.

National Bank of Ethiopia (NBE) has the job of

computing the CPI.

The NBE weights different items by computing the

price of a basket of goods and services purchased by
a typical consumer. The CPI is the price of this basket
of goods & services relative to the price of the same
basket in some base year.
Cost of a Market Basket of Products at Current Prices
CPI   100
Cost of the Same Basket of Products at BaseYear Prices

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The CPI differs from the GDP deflator in three main
ways:
 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.

 The second difference is that the GDP deflator includes

only those goods produced domestically; i.e. Imported
goods are not part of GDP and do not show up in the
GDP deflator.
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 The third difference is that CPI measures the cost of a
given basket of goods and services, which is the same
from year to year.
− The basket of goods & services included in the GDP
deflator, however, differs from year to year, depending on
what is produced in the economy in each year. In other
words, the CPI assigns fixed weights to the different
goods, whereas the GDP deflator assigns changing
weights;
− Economists call a price index with a fixed basket of goods
a Laspeyres Index and a price index with a changing
basket a Paasche Index;
− Neither of these two price indices is clearly superior to the
other in measuring the cost of living; and
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− Moreover, the difference between them is usually not
large in practice. Thus, the CPI is also used to deflate
nominal GDP so as to arrive at the real GDP.

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GDP, Economic Growth and Welfare

GDP is a reasonably accurate and extremely useful

measure of national economic performance.

How good is GDP as a measure of national welfare?

Total welfare depends on a number of factors such as
leisure, security etc.

That is, welfare depends not only on income but also

other factors that affect the quality of life. Therefore, it
is not, and never intended to be, an index of social
welfare.
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There are important items affecting our wellbeing that
are not included in GDP.

Hence, GDP is not a perfect measure of welfare, since

it does not take into account several factors like:
1. Pure financial transactions are excluded: Gov’t transfer
payments (social security or cash welfare benefits), private
transfer payments (student allowances or alimony), and
the sale of stocks & bonds b/c they represent transfer of
existing assets but the brokers’ services.

2. Non-market goods & services are not included in GDP.

E.g. Household activities: Household services (house
cleaning, childcare, meal preparation, home repair
maintenance) are excluded.
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3. Leisure: GDP does not consider the satisfaction that
people get from leisure time (recreational activity).
GDP then understates social wellbeing.

4. Distribution of Income: GDP does not account for

changes in the distribution of income across hhs. It
does not tell us anything about whether output is
distributed fairly/equally or not.

5. The Informal Economy: This includes transactions of

output that are not in the government’s statistics b/c
they are difficult to measure and they are illegal. Thus,
Illegal and underground economic activities are not
included in GDP b/c these activities are not reported.
In this sense, GDP understates welfare.
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6. Loss & cost of environmental damage, and the
economic bads: GDP accounting also ignores the
depletion of natural resources.
 It also ignores environmental degradations like
pollutions (air, water & sound), and it ignores crime,
traffic congestion, etc. (which make us worse off).
 The costs of environmental damage are not subtracted
from the market value of final products when GDP is
calculated. Thus, It over estimates the value of output.

7. Does not distinguish between production that makes

us better off and production that prevents us from
becoming worse-off (Goods Vs Bads). E.g. Traffic
accidents Vs insurance and legal services.
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8. Volunteer works are not incorporated; and

9. Ignores quality of output: It is difficult to take into

account of the changes in the quality, composition and
distribution of goods & services.

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