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CHAPTER 1
1. THE STATE OF MACROECONOMICS

1.1 Definition of Macroeconomics

Modern economists divide the subject economics into two compartments, i.e. microeconomics and
macroeconomics. The subject matter of economics is analyzed either through the micro analysis or macro
analysis. Micro is to mean “small” and macro means “big”. This implies, macroeconomics is not concerned
with one particular unit, but with all units combined together. Macroeconomics studies the working of an
economy in aggregation or averages. In short, macroeconomics can be defined as follows.

Definition: Macroeconomics is a branch of economics that deals with aggregate components of an economy.

1.2 Scope of Macroeconomics

The macroeconomics policy of any country focuses on achieving the following three most important
objectives which are the problems those form the scope of macroeconomics. These are:
1. Economic growth. This refers to the growth of output (GDP) in an economy. Usually, letter Y
represents output or GDP in macro models.
2. Stability of the economy. This refers to achieving low or stable inflation (Л), nominal interest
rate (r), and exchange rate (USD to Birr ratio).
3. Reducing or addressing unemployment, particularly the cyclical unemployment, which is the
outcome of poverty.
Even though there are four unemployment types in an economy, economic policy makers give due attention or
emphasize on addressing the cyclical unemployment which could be permanent unless they are capable of
using different macroeconomics instruments. But frictional and structural unemployment are caused as a
result of poor or imperfect information and change in technology respectively and can be addressed easily.
Therefore, their effect on an economy is temporary. We will see the details of the unemployment types on the
coming chapters.

1.3 Macroeconomic instruments:

To achieve the above three objectives economic policy makers of countries use mix of macroeconomic
instruments. The most important instruments among others include monetary policy, fiscal policy, income
policy, and labour policy. Macroeconomic thinking has stages of evolutions. Throughout its stages of

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development, there has been consensus that the above three are the main objectives of macroeconomics.
However, schools of thoughts disagree on the policy instruments they prescribe to achieve them.

1.4 Evolution and development of Macroeconomics

Economic thinking has begun since the cradle/birth of mankind/human being. This is because archeological
excavations evidenced that our ancestors (ancient mankind) were having some economic thinking such as
saving due to scarcity of resources and division of labour even when gathering and hunting were their means
of survival/basic livelihood. Further studies made in ancient civilizations of Egypt, Babylon, Persia, Axum,
China, India, Byzantine, Greek, and Rome confirms that trade and tax were the sources of their civilization.
The above findings, therefore, attest that people make economic decision since birth at different age levels
(child, youth, adult, and old) to death whether knowingly or unknowingly.

Available document, however, suggest that formal study on economic issues was started around 2nd century
AD in ancient Greek philosophy/wisdom. This implies that economics is an old science like Art, literature,
Astronomy, Mathematics, Physics, Medicine, and the like.

Plato and Aristotle were the two prominent ancient Greek philosophers who produced enormous economic
articles on economics that served as foundation/basis for further studies and advancement of economics.
However, the studies of scholars conducted on economic issues and theories developed up to the industrial
revolution of the 18th century focus only on microeconomic issues.

The earliest macroeconomic thinking started from the days of “mercantilists” when was concerned with the
government policies for the promotion of economic growth of economic resources. After mercantilists the
physiocrates also looked at the economy as a whole and analyzed the circular flow of wealth Quesnay’s
Tableau economique” (1758) represented the first systematic attempt in national income analysis (Although
macroeconomics owed its systematic origin to Adam Smith after his writing “The wealth of Nation” in 1776).
A part of classical literature was a mixture of microeconomic theories. Smith and his followers assumed full
employment and aggregate output as given. They believed in the invisible hand which managed the whole
economic system.

Modern macroeconomic thinking originated from four main sources. Which are:-

1. The concept of circular flow of payments. It was a leading concept of the physiocrates. It was later
developed by Schumpater and Walras.

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 2. The concept of national dividend or national income: - it was propounded by Marshall and later
developed by Pigou.
3. The main approach to the values of money responsible for the development of concepts like aggregate
demand and supply and their components like aggregates cost of saving and investment.
4. The Analysis of trade cycles.

1.5 Schools of thought in Macroeconomics

There have been two main intellectual traditions in macroeconomics. One school of thought believes that
markets work best if left to themselves. The other believes that government intervention can significantly
improve the operation of the economy. Accordingly, here are the three major trends on theories of modern
economics.

A. Classical school of thought (1776 - 1870). This is the era of the marginalist approach (thought).
During this period, macroeconomics was not distinct from that of micro.
The dominant idea of this school of thought was the invisible hand or lasiez fair, which means leave the
market free (free market) advocated by Adam Smith. The reason for their argument was that because
supply will create its own demand or price set by the private sector alone will automatically
correct/equilibrate any imbalance or disequilibria created in the economy both in the short run and the long
run without government intervention. This law is called the “Says law”.
 Adam Smith also described the government as the necessary evil and hence advocated that the
government should stay away or refrain from intervening in the market. For Adam Smith and his
followers any government policy is ineffective to correct economic disorder or disequilibrium. In other
words, government intervention will distort the market rather than stabilizing.
 From the above arguments of the classical school of thought concepts such as price, economy, and the
government are macro concepts. However, they did not have clear vision of how the economy should
operate.
B. The neo-classical school of thought (1870-1936). The idea of this school of thought was not different from
the classical. The change in economic theory from classical to neoclassical economics has been called the
'marginal revolution. The neoclassical economists provided foundation for the “marginal analysis”. The
rational people look at the margin or edge (small incremental addition to a plan of action) to maximize
their objectives such as maximization of profit, maximization of utility, maximization of productivity, etc.
They began to look at the margin in economic analysis. For example, marginal revenue (what would be
the additional unit of revenue if the seller sale one more unit of commodity. I.e. Changes in total revenue
as a result of the sales of one more unit of commodity), marginal product. For example, what would be the

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 contribution of adding one more factor in the additional unit of production?). Neoclassical economists
advanced the use of optimization techniques in analyzing economics to allocate resources optimally.

C. The Keynesian macroeconomics (1936-1975). An American economist called Keynes

challenged/criticized the classical wisdoms of macroeconomics based on the events or episodes during
the great economic depression of the early 1930s (1929 to 1935). The great depression was caused by
excessive or overproduction of wheat and coffee. Due to excess production than demanded the price of
wheat and coffee goes down, implying supply fails to create its demand as argued by the classical.

1.6 Economic Systems

Market economy: An economy that allocates resources through the decentralized decisions of many firms
and households as they interact in markets for goods and services. Market economy uses market mechanism
to allocate resources in an economy. In market, buyers and sellers are interacted to determine prices and
exchange goods, services and assets.
Command Economy: In command economy, government control and decide allocation of resources through
the centralized planning body in the country. Decisions are taken by government regarding what has to be
produced in the economy and what has to be consumed by the people.
Mixed economy: In mixed economy, country will follow both market mechanism and government control in
allocation of resources in the economy. You can see both private corporation and state promoted public
companies in such economy. At present, most countries are following mixed economy type in the current
world.

1.7 Macroeconomic variables

A variable is a magnitude which can be measured on a scale and which varies. Macroeconomics can have any
number of variables which can be categorized as one of the following three types.
(i) Stock, (ii) Flow and (iii) Ratio

A stock variable has no time dimension, while a flow variable has. One can measure a stock variable at some
point in time but it’s magnitude has no dimension on the other hand a flow variable can only be expressed per
unit of time. For instance, money is stock but transactions or expenditures in money are flow or saving per
month is flow while savings accumulated up to certain specific date is a stock.

A ratio variable is one which expresses relationship between two flows or two stocks and between stocks and
flows. For example, price is the ratio of flow of cash to a flow of goods. It doesn’t have any dimension.

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 CHAPTER 2
2. NATIONAL INCOME ACCOUNTING

2.1 Meaning and Approaches of National Income Accounting

National income is the sum of all individual incomes, such as the total sum of (i) all wages, salaries,
commissions and labour incomes before payment of taxes and social security contributions. (ii) Interest
income from bonds, mortgages, loans, etc. after deducting interest paid on government debts, (iii) rental
income from real property and royalties, and (iv) profit of corporation, partnership or proprietorship, before
deduction of taxes based on income.

In this connection let us see different approaches adopted by different economists to define national income;
These approaches are:
1. The Traditional approach,
2. The Keynesian approach and
3. The Modern approach

1. Traditional Approach

(i) Fisher’s definition. In the words of Fisher, “the national dividend or income consists solely of services as
received by ultimate consumers, whether from their material or from their human environment. From this
definition, fisher adopts consumption as the basis of national income. But it has the following short comings.
- Net consumption cannot be estimated easily
- The value of services rendered by consumer durables year after year cannot be measured
- Consumer durables also keep on changing hands and therefore the change of ownership also creates
difficulties.
(ii) Marshal’s definition. According to Marshal, “The labour and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material and immaterial, including
services of all kind. This is the true net national income or revenue of the country or national dividend.”

Hence, according to Marshal;

 All types of goods and services which are produced, whether they are brought to the market or not, are
included in the national income.

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  The cost of wear and tear of the machinery should be deducted from the total value of these goods and
services. The remaining could be the national income. That is why marshal has used the term “net”.

 Income from abroad has also to be taken into account while computing the national income

But the goods and services produced in a country are so numerous that it is not easy to make out a correct
estimate of the total production. There is a difficulty of double counting which implies that a particular
commodity (as a raw material as well as finished product) may get included in the national income.

(iii) Pigou’s definition. In the words of Pigou; “National income is that part of the objective income, of the
commodity, including of course, income derived from abroad, which can be measured in money”. The
main points of the definition are given below.

 Only goods and services exchanged for money are included in the national income.

 Income earned from investment in foreign countries has also to be counted while computing national
income.

Goods those do not exchanged for money and services rendered to one self or to family or friends without any
payment are not to be included in the national income.

2. Keynesian Approach

According to Keynes three approaches can be adopted to compute national income. These are;
A. Expenditure approach
B. Income approach, and
C. Sales minus Cost approach.

A. Expenditure Approach

According to this approach, national income is equal to total consumption expenditure and total investment
expenditure. Systematically, it can be expressed as follows:

Y=C+I
Where
Y is national income
C is consumption expenditure and
I is investment expenditure.

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B. Income approach.

According to this approach national income is the total income of all the factors of production. Symbolically,
it can be expressed as under:
Y= R+EP
Where, Y is the national income, R is the payments received by owners of factors of production and EP
represents entrepreneurial profits.

D. Sales – minus - Cost approach.

According to this approach, national income is equal to the total sale of products minus user cost.
Symbolically, it can be expressed as below:
Y=Q - C
Where, Y is the national income, Q is gross national product, and C is aggregate user cost.

3. Modern Approach ,

Modern approach has considered the concept of national income in its three aspects;
i) Product aspect
ii) Income aspect and
iii) Expenditure aspect.

And they stress up on the existence of fundamental identity between them. Then view national income as a
flow of output, income and expenditure, when goods are produced by firms the owners of various inputs
receive income in the form of wages, profits, interest, and the remaining is saved. The amount saved by the
households is mobilized by the produces for investment spending. Thus, there is a circular flow of production,
income and expenditure. These three flows are always equal per unit of time. Hence, total output = total
income = total expenditure.

2.2 Main Features of National Income Concepts

The chief features of the concept of national income are:-
1. National income is a flow and not a stock.
2. National income, in real terms, is the flow of goods and services produced during a particular period by an
economy.
3. National income, in money terms, is the money measure of the aggregates of all goods and services
available to the nation in a particular period.
4. National income is always expressed with reference to a particular period of time (usually a year).
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5. The concept of national income is visualized as a law of national output, national income and national
expenditure. And these three flows are equal to each other.

2.3. Measuring the Performance of an Economy

The purpose of any economic activity is to satisfy human wants by providing goods like food, shelter,
equipment, and services like medical services and recreation etc. Thus, society produces various goods and
services. One of the major objectives of macroeconomics is to introduce the method of measuring the GDP or
GNP of a nation. The measure of the monetary value of all goods and services that are produced in a country
in one year is the national income of a country. The most widely used measures of national income are Gross
Domestic Product (GDP) and Gross National Product (GNP).

Gross Domestic Product (GDP): is the market value of all final goods and services produced by resources
located within a country regardless of ownership of the resource during a year. It takes in to account the
geographical boundary. It is the money value of annual production (output) of a nation produced within the
boundary of a given country in a market price. Production is the activity that transforms inputs in to goods and
services used for various purposes. For instance, the shipping of goods from factories to buyers and the
services provided in a health station are the productive activities. One of the major goals of macroeconomics
is to achieve full production. When an economy is producing at its maximum capacity of production as much
as it possibly can with its available resources, full production will occur. The other macroeconomic goal is
economic growth. Economic growth refers to an increase in the level of output or an increase in full
production or full employment over time. Economic growth can be achieved either by increasing the available
resource i.e. increasing the quantities of economic resources or improving the quality of economic resources
through education or on job training or improving technology (technological advancement). For instance,
improving the quality of factors of production like labor by giving on job training or education will allow
productive capacity to grow. You remember from previous courses that economic growth would occur when
the production possibilities curve shifts to the right. Therefore, when an economic growth occurs, more
consumer and capital goods can be produced and the production possibility curve shifts to the right (out
ward).

Gross National Product (GNP): is the market value of all final goods and services produced by resources
owned by citizens of a country during a year. It measure the money value of all finished goods and services
produced in an economy in a given year. In general, GNP measures the money value of output produced by
every citizen of that country regardless of whether he/she is currently living in the country while GDP
measures the money value of output produced by everyone living within the borders of the country. In order
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to avoid double counting, in this type of measurement, only finished goods and services that are ready for sale
to their final users should be included. Otherwise, if we include products in a stage of production or
intermediate products (products that may be used as input for other production process) then production will
be overstated. GNP measures the value of goods and services produced not goods and services sold in a given
year. Hence, second hand sales are not included in the GNP because these goods were previously counted in
GNP.

Here under is the explanation of the three possible approaches to measure gross national product (GNP) or
gross domestic product (GDP).

1. The Output Approach

This is the method of measuring GNP by adding up the market value (monetary value) of output of all firms
in the country. In this method of measuring GNP, it is important to include only final goods and services in
order to avoid double counting. Double counting will arise when the output of some firms are used as the
inputs of other firms but there are two possible ways of avoiding double counting. These are: taking only the
value of final goods and services and taking the sum of the value added by all firms at different stages of
production.

Value of final goods and services

When we say final goods and services, we mean goods and services, which are being purchased for final use
and not for resale or further processing. On the other hand, intermediate goods refer to purchase or goods and
services for resale or for further processing or manufacturing. Therefore, to avoid double counting, the sale of
final goods should be included and the sale of intermediate goods should be excluded from GNP because the
value of final goods already includes the value of intermediate goods involved in their production.

The sum of the value added methods

To avoid double counting, it is also necessary to use value added method. Value added is the market value of
firm’s output less the value of the inputs purchased from others. Thus, by summing the values added by all
firms in the economy, GNP can be determined.

2. Expenditure Approach

To determine GNP using expenditure approach, we must add up all types of spending of final goods and
services. Expenditures can be categorized into 4 groups depending on who buys the goods or services. We
examine these categories as follows:

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  Personal consumption expenditure (C)
 Gross private investment (I)
 Government purchase of goods and services (G)
 Net export (NE)

Personal consumption expenditure (C)

Personal consumption expenditure includes expenditures by households on durable goods like cars,
refrigerators, TV etc, non-durable goods like bread, beer, pencil, tea etc and for services like barber,
restaurant, lawyer, mechanics etc.

Gross private Domestic investment (I)

It refers to all investment spending by business firms. Investment includes all purchases of machinery,
equipment and tools by business enterprise, all construction like building of a new factory and change in
inventories. Investment also includes residential construction. This is because like factories, residential house
are income-earning assets. That means they can be rented to yield money income as a return.

Since GNP measures the value of output produced in a given year, in order to get accurate measures of GNP,
we must include the market value of inventories, which are produced in the given year but not sold in the
same year. If we exclude inventories from GNP, then it would understate the given year’s total production.

If business firms have more goods on their shelves, then the economy has produced more than it has
consumed during the given year. This increase in inventories should be added to GNP. On the other hand, if
there is a reduction in inventory, then the economy sells output, which exceeds current production. This
reduction in inventory must be subtracted from GNP, because GNP measures the value of current year’s
output. However, investment does not include the transfer of money or assets. It does not also include the
buying of stocks and bonds, because such purchases transfer the ownership of existing assets. In general, the
resale of existing assets will not be included in investments.

Therefore, gross private domestic investment include the production of all investment goods, which include
the additions to the stock of capital and replacing the machinery, equipment and building used up in the
current year production.

In short, gross private investment includes added investment and depreciation. If we take only the added
investment, which has occurred in the current year, then we get net private investment.

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 Net private investment = Gross private investment – depreciation

Where depreciation is the allowance made for tear and wear out of capital.

From the above relationship, you can observe the following points:

 When gross investment exceeds depreciation or when net investment is positive, the economy is
expanding (growing) i.e. its stock of capital is growing.
 When gross investment and depreciation are equal or when net investment is zero, the economy is
static economy i.e. it is producing enough capital to replace what is consumed in producing the given
year’s output
 Whenever gross investment is less than depreciation or whenever net investment is negative i.e. when
the economy uses up more capital than it produces, the economy will be disinvesting (declining). In
other words, when depreciation exceeds gross investment, the nation’s stock of capital is less at the
end of the year than at the beginning of the year.

Example:

The following example will enable you to identify the difference between net investment and gross
investment.

Suppose in 2015, a certain economy produced about 10 billion birr worth of capital goods. However,
in the process of producing, the economy used up 3 billion birr worth of machinery and equipment.
Determine the net private investment

Solution

Since 10 billion Birr worth of capital goods private investment and 3 billion Birr worth of machinery
and equipment are the value of the capital used up in the production processes (depreciation) in 2015,
the difference between the two (10 billion – 3 billion = 7 billion birr) is the net private investment of
the given economy in 2015.

Government purchases of goods and services (G)

It includes all government spending at different layers of the government like at federal, state and local levels
on final goods and services. However, it excludes all government transfer payments because such payments
don’t reflect current production.
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Net export (NE)

Net export (NE) = Export –Import

Spending by foreigners in a certain country may contribute just as spending by the citizens. Hence, we have
to add the value of net export in determining GNP. On the other hand, the value of import (produced abroad)
do not reflect productive activity of a country, thus should be subtracted. Net export is the difference between
the amounts by which foreigner spending on a certain country and the amount of citizens spending on foreign
country. In other words, net export is the difference between export and import

From the above relationship, you can observe the following points:

 When export exceeds import, net export is positive.

 When export is equal to import, net export is zero.
 When export is less than import, net export is negative

For example, foreign countries buy 5 billion dollar worth of capital from country X (i.e. export) and country X
buys 4 billion dollar worth of capital from foreign countries (i.e. import) in a given year, net export of country
X will be 1 billion dollar (5 billion dollar – 4 billion dollar).

In general, the value of gross domestic product of any economy will be given as:

GDP = C + Ig + G + NE

A country may own resources in foreign country, which leads to a flow of income from abroad in to the
country, denoted by I1, similarly resources owned by foreigners in a country may lead to outflow of income to
abroad from the country, denoted by I0 the difference between income inflow (I1) and income outflow (I0) is
known as net factor income from abroad.

Net I = I1 – I0

Hence, the relationship between GNP and GDP is given as:

GNP = GDP + net income from abroad

GNP = GDP + (I1 – I0 )

You can observe the following relationship:

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  when I1 > I0 , GNP exceeds GDP
 when I1 = I0 , GNP equals GDP
 when I1 < I0 , GNP is less than GDP

Example:

This example will help you to develop your skill of computing GNP and/or GDP using the following
hypothetical data of a certain country answer the questions below.

Value in billion birr

1. Capital consumption allowance (depreciation) 1220
2. Personal consumption expenditure 6320
3. Government spending on goods and services 5000
4. Transfer payment 650
5. Income earned by foreigners in the country 500
6. Net investment 5780
7. Income earned by citizens abroad 800
8. Export 500
9. Import 750

Using the appropriate method, calculate GDP and GNP

Solution

GDP= C + Ig + G + NE
= C + net investment + depreciation + G + NE
Where GDP = Gross domestic product
C= personal consumption expenditure
Ig = Gross private investment
G= Government purchases of goods and services
NE = net export
GDP = 6320 + 5780+ 1220+5000+500-750
GDP = 18070 billion birr
GNP = GDP + (I1 – I0)
= GDP + (I1 – I0)

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 = 18070+800 -500
GDP = 18370 billion birr

How was this 18370 billion birr of expenditure of the hypothetical country allocated or distributed as income.
It would be simple if we could say that total expenditures on the economy’s yearly output flow to households
as wages, rent , interest, and profit incomes but the picture is complicated by two non-income charges against
the value of total output. These are consumption of fixed capital (depreciation) and indirect business taxes. In
the coming section, you will see the methods of measuring the performance of an economy using income
approach.

3. The Income Approach

According to this method, payments received by all citizens of the country that have contributed in the current
year production are added to get gross national product. Hence, gross national product using income approach
includes compensation to employees, rent, interest, profit, depreciation and indirect business tax and subsides.

Compensation to employees (C)

It includes wages and salaries and their supplements like employer’s contributions in social security, pension,
health and welfare funds, which are paid by business firms and government to suppliers of labor.

Rents (R) are payment to households that supply property resources.

Interest (I) refers to payments by private firms to household which supply capital. However, interest payment
made by government is excluded.

Profit (Π) includes proprietors’ income (profit of unincorporated business) and corporate profit. Proprietors’
income refers to the net income of sole proprietors, partnerships and corporations. While corporate profits
include corporate income taxes (part flow to government), dividends (part divided to stock holders) that are
payment flow to households and undistributed corporate profits that are retained as corporate earnings.

Depreciation (capital consumption allowance) (D)

The annual payment, which estimates the amount of capital equipment used up in each year’s production, is
called depreciation. It represents a portion of GNP that must be used to replace the machinery and equipment
used up in the production process.

Indirect business tax (IBT)

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The government imposes indirect taxes on business firms. These taxes are treated as cost of production.
Therefore, business firms add these taxes to the prices of the products they sell. Indirect business tax includes
sales taxes, excise taxes and custom duties etc.

Therefore, GDP and GNP using income approaches are given as follows:

GDP = C+ R+ I+ II+ D+ IBT – subsidy

GNP=GDP + net income from abroad

Example:

By doing the following example, you will be able to compute GNP and/or GDP using income approach.
Given the following hypothetical data of a certain country, answer the questions below;

Types of income Amount (in billion birr)

Compensation of employees 10,800
Proprietor’s income 400
Rental income 600
Corporate profit 4000
Net interest 170
Deprecation 1600
Indirect business taxes 200
Income earned by foreigners in the country 500
Income earned by citizens abroad 800

1. Compute GDP using income approach

2. Compute GNP using income approach

Solution

1. GDP using income approach is determined as follows:

GDP = C + R +I + II + D + IBT
GDP = 10800+ 600+ 170 + 400 + 4000 + 1600 + 200 = 17770 billion birr
2. GNP = GDP + Net income from abroad
GNP = 17770 + 800 – 500 = 18070 billion birr

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Nominal and Real Gross National product

GNP is given in two forms. These are Nominal GNP and real GNP. Nominal GNP (NGNP) measures the
money value of all finished goods and services according to price during the year in which the goods and
service are produced. That means it measures the value of current production in terms of current prices.
This type of measurement can be influenced by both changes in the price and production (output).

Real GNP (RGNP) measures the money value of all finished goods and services using a certain base year
price. Real GNP is nominal GNP adjusted to eliminate inflation. It is preferable than nominal GNP because
it indicates the state of the economy and it is important for analyzing production condition. While
measuring an economy using nominal GNP, inflation distorts what actually happened to production. Thus,
evaluating the economy using nominal GNP would be misleading.

In order to calculate real GNP, it is necessary to have measure of price changes over the years, i.e. price index,
using one year as a base year. This price index or GNP deflator provides the mechanism for converting
nominal GNP to real GNP.

Real GNP = Nominal GNP for the given year X 100

For the given year GNP deflator for that year

Thus, real GNP for a given year is found by dividing that year’s nominal GNP by that year’s GNP deflator
and then multiplying by 100.

Other Social Accounts

In addition to GNP, there are also other social accounts, which can be derived from GNP and has equal
importance. Hence, in this section we will see additional social accounts.

These are:

 Net national Product (NNP)

 National Income (NI)
 Personal income (PI)
 Personal disposable income (PDI)

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 Net National product (NNP)

GNP as a measure of the economy’s annual output may have defect because it fails to take into account
capital consumption allowance, which is necessary to replace the capital goods used up in that year’s
production. Hence, net national product is a more accurate measure of economy’s annual output than gross
national product because it takes capital consumption allowance or depreciation in to account and it is given
as:

Net National product =Gross National product – Capital consumption allowance

(NNP) (GNP) (D)

National income (NI)

National income is the income earned by economic resource (input) suppliers for their contributions of land,
labour, capital and entrepreneurial ability, which involved in the given year’s production activity. It measure
the income received by resource supplier for their contributions to current production. However, from the
components of NNP, indirect business tax, which is collected by the government, does not reflect the
productive contributions of economic resources because government contributes nothing directly to the
production in return to the indirect business tax. Hence, to get the national income, we must subtract indirect
business tax from net national product.
National income = Net National product – indirect business tax + subsidies
(NI) (NNP) (IBT) (S)

Personal income (PI)

Part of national income like social security contribution (payroll taxes), and corporate income taxes are not
actually received by individuals. Therefore, they should be subtracted from the national income. On the other
hand, transfer payment, which include welfare payments, veterans’ payments, unemployment compensation,
are not currently earned. Therefore, in order to get personal income (PI) which is a measure of income
received by individuals, we must subtract from national income those types of income which are earned but
not received and add those types of income which are received but not currently earned.

Personal income (PI) =National income (NI) - social security contribution (SSC) -
corporate profits -Net interest + transfer payment + Dividend + personal interest income

Personal Disposable Income (PDI)

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Personal disposal income is the difference between personal income and personal income taxes. It is the
amount of income which households divided it as saving and consumption. Personal taxes include personal
income taxes, personal property taxes and inheritance taxes.

Personal Disposable Income = personal income – personal income taxes

(PDI) (PI) (PIT)

2.4 Nominal GDP versus Real GDP

Economists use the rules just described to compute GDP, which values the economy’s total output of goods
and services. But is GDP a good measure of economic well-being? Consider once again the economy that
produces only apples and oranges. In this economy GDP is the sum of the value of all the apples produced and
the value of all the oranges produced. That is, Notice that GDP can increase either because prices rise or
because quantities rise.
It is easy to see that GDP computed this way is not a good gauge of economic well-being. That is, this
measure does not accurately reflect how well the economy can satisfy the demands of households, firms, and
the government. If all prices doubled without any change in quantities, GDP would double. 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. Economists call the value of goods and services measured at current prices
nominalGDP.
A better measure of economic well-being would tally the economy’s output of goods and services and would
not be influenced by changes in prices. For this purpose, economists use real GDP, which is the value of
goods and services measured using a constant set of prices. That is, real GDP shows what would have
happened to expenditure on output if quantities had changed but prices had not.
To see how real GDP is computed, imagine we wanted to compare output in 2011 and output in 2012 in our
apple-and-orange economy. We could begin by choosing a set of prices, called base-year prices, such as the
prices that prevailed in 2011. Goods and services are then added up using these base-year prices to value the
different goods in both years. Real GDP for 2011 would be:
Real GDP = (2011 Price of Apples *2011 Quantity of Apples) +(2011 Price of Oranges *2011 Quantity of
Oranges).
Similarly, real GDP in 2012 would be: Real GDP = (2011 Price of Apples *2012 Quantity of Apples) + (2011
Price of Oranges *2012 Quantity of Oranges).
And real GDP in 2013 would be: Real GDP =(2011 Price of Apples *2013 Quantity of Apples) + (2011 Price
of Oranges *2013 Quantity of Oranges).

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Notice that 2011 prices are used to compute real GDP for all three years. Because the prices are held constant,
real GDP varies from year to year only if the quantities produced vary. Because a society’s 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.

2.5The GDP Deflator and the consumer price index

2.5.1 The GDP Deflator
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:
GDP Deflator =Nominal GDP/Real GDP
.The GDP deflator reflects what’s happening to the overall level of prices in the economy.
To better understand this, consider again an economy with only one good, i.e bread
The total amount of birr spent on bread in that year will be, 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).
The definition of 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.
Nominal GDP measures the current dollar value of the output of the economy. Real GDP measures output
valued at constant prices. The GDP deflator measures the price of output relative to its price in the base year.
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. For most purposes, however, the
differences are not important. It turns out that the two measures of real GDP are highly correlated with each
other. The reason for this close association is that most relative prices change slowly over time. Thus, both
measures of real GDP reflect the same thing: economy-wide changes in the production of goods and services.
2.5.2 The Consumer Price Index (CPI) (
Measuring the Cost of living: A dollar today doesn’t buy as much as it did twenty 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.
The Price of a Basket of Goods: The most commonly used measure of the level of prices is the consumer
price index (CPI). It can be computing by collecting the prices of thousands of goods and services. Just as
GDP turns the quantities of many goods and services into a single number measuring the value of production,
the CPI turns the prices of many goods and services into a single index measuring the overall level of prices.

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How should economists aggregate the many prices in the economy into a single index that reliably measures
the price level? They could simply compute an average of all prices. Yet this approach would treat all goods
and services equally.
Because people buy more chicken than caviar, the price of chicken should have a greater weight in the CPI
than the price of caviar. The CPI is the price of this basket of goods and services relative to the price of the
same basket in some base year.
For example, suppose that the typical consumer buys 5 apples and 2 oranges every month. Then the basket of
goods consists of 5 apples and 2 oranges, and the CPI is

CPI = . (5 XCurrent Price of Apples) (2 XCurrent Price of Oranges)

(5 X2012 Price of Apples) (2 X2012 Price of Oranges)

In this CPI, 2012 is the base year. The index tells us how much it costs now to buy 5 apples and 2 oranges
relative to how much it cost to buy the same basket of fruit in 2013.
The consumer price index is the most closely watched index of prices, but it is not the only such index.
Another is the producer price index, which measures the price of a typical basket of goods bought by firms
rather than consumers. In addition to these overall price indexes, there are also price indexes for specific types
of goods, such as food, housing, and energy.
Another statistic, sometimes called core inflation, measures the increase in price of a consumer basket that
excludes food and energy products. Because food and energy prices exhibit substantial short-run volatility,
core inflation is sometimes viewed as a better gauge of ongoing inflation trends.
2.5.3 The CPI versus the GDP Deflator
The GDP deflator is the implicit price deflator for GDP, which is the ratio of nominal GDP to real GDP. The
GDP deflator and the CPI give somewhat different information about what’s happening to the overall level of
prices in the economy. There are three key differences between the two measures.
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 only 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. 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 this country affects the CPI, because the Toyota is bought by consumers,
but it does not affect the GDP deflator.
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
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 GDP deflator allows the basket of goods to change over time as the composition of GDP changes. The
following example shows how these approaches differ.
Suppose that major frosts destroy the nation’s orange crop. The quantity of oranges produced falls to zero, and
the price of the few oranges that remain on grocers’ shelves is driven sky-high. Because oranges are no longer
part of GDP, the increase in the price of oranges does not show up in the GDP deflator. But because the CPI is
computed with a fixed basket of goods that includes oranges, the increase in the price of oranges causes a
substantial rise in the CPI.
2.6 GDP and Welfare
Gross Domestic Product (GDP): is the value of all final goods and services produced in a country in one
year. A country's annual production or income can be measured using variables such as GDP and GNP. The
increase in GDP helps to expand public and social infrastructure and income of households.
Welfare: It is the responsibility to provide a minimum standard of subsistence to citizens and provision of
extensive service the people. Hence, it is related to happiness or prosperity. It is interest or preference for life
to go badly or well. Welfare includes non profit functions of society, interventions such as education, health,
housing, income maintenance and other government activities that seek to prevent, alleviate or contribute to
social problems or improve the wellbeing.
2.7 A Real-Business-Cycle Model
In this section we turn our model of the economy under flexible prices into a model of fluctuations. The new
feature of the model is the behavior of labor supply. In the classical model discussed so far, the supply of
labor is fixed, and this fixed supply determines the level of employment. Yet employment fluctuates
substantially over the business cycle. If we want to maintain the classical assumption that the labor market
clears, as new classical economists do, then we must examine what causes fluctuations in the quantity of labor
supplied.
After discussing the determinants of labor supply, we modify our classical model of aggregate income to
include changes in labor supply. The supply of goods and services depends in part on the supply of labor. The
greater the number of hours people are willing to work, the more output the economy can produce. We
examine how, according to real-business-cycle theory, various events influence labor supply and aggregate
income.
Fig. 2.1 Phases of business cycle

B
GNP A
C
E Equilibrium GNP

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 D
Time
Business cycle has four phases: as follow
A-B Expansion phase
B-C Recession phase
C-D Depression phase
D-E Recovery phase
 Point B is the peak which indicates period of economic prosperity. While point D is through which
indicates economic depression
A period of prosperity is characterized by high output, high employment, high price and profit. While
depression is characterized by low output, income high unemployment and low price
2.7.1 Inter-temporal Substitution and Labor Supply
Real-business cycle theory emphasizes that the quantity of labor supplied at any point in time depends on the
incentives that workers face. When workers are well rewarded, they are willing towork more hours; when the
rewards are less, they are willing to work fewer hours. Sometimes, if the reward for working is sufficiently
small, workers choose to forgo working altogether-at least temporarily. This willingness to reallocate hours of
work over time is called the inter-temporal substitution of labor.
According to real-business-cycle theory, all workers perform the cost benefit analysis, to decide when to work
and when to enjoy leisure. If the wage is temporarily low or if the interest rate is low, it is a good time to
enjoy leisure.
Real-business-cycle theory uses the inter-temporal substitution of labor to explain why employment and
output fluctuate. Shocks causes to the economy that the interest rate to rise or the wage to be temporarily high
cause people to want to work more. The increase in work effort raises employment and production.
2.8 Unemployment and inflation
2.8.1 Unemployment

Unemployment can be defined people who are out of work but are actively seeking to reenter the work force.

Full employment and Underemployment: A society is almost never fully employed, but one of the goals is
to reach full employment. Full employment has two conditions: Everyone who wants to work is working, and
the rate of inflation is stable. When the economy is at full employment, there is no cyclical unemployment but
still frictional and structural unemployment. This is defined as natural unemployment.

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  You are only classified as unemployed if you go and register with the government as available for
work.
 The labor force is defined as those of 16 years of age or older who are employed plus all those who are
unemployed seeking work.
 Unemployment rate : the number of people with no work expressed as % of the labor force
 Cost of unemployment: There are numerous costs of unemployment. For one thing, demand-side
unemployment may be a slippery slope. For another thing, there are social costs such as high crime
rates. There is a loss in potential output. There is political unrest brought by high levels of
unemployment.
 Problems with Unemployment: Cost to individual, lower income and quality of lifelower self-
esteem, leading to stress and erosion of mental health, cost to Society and areas with high
unemployment can see increased crime, destruction and gang activity and cost to the economy in
general.
2.8.1.1 Types of unemployment
A) Seasonal unemployment

Is a periodic unemployment. E.g. Agricultural workers suffer from unemployment during agricultural lean
seasons. Workers in developed countries can however easily switch skills to meet varying labor demands. It
can also be countered through government intervention. In addition to the laborers, regular seasonal changes
in employment / labour demand affects certain industries more than others such as: Catering and leisure,
Construction, Retailing, Tourism and Agriculture.
B) Frictional unemployment

Is a transitional unemployment due to people moving between jobs: Includes people experiencing short spells
of unemployment, and new and returning entrants into the labour market
Imperfect information about available job opportunities can lengthen the period of someone’s job search. In
general, Frictional unemployment refers to the unemployment that results from the time that it takes to match
workers with jobs. In other words, it takes time for workers to search for the jobs that are best suit their tastes
and skills.
C) Structural unemployment

Arises from the mismatch of skills and job opportunities as the pattern of labour demand in the economy
changes and often involves long-term unemployment. This type of unemployment is prevalent in regions
where industries go into long-term decline. Good examples of structural unemployment include industries
such as mining, engineering and textiles.

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Structural unemployment is the unemployment that results because the number of jobs available in some labor
markets is insufficient to provide a job for everyone who wants. It occurs when the quantity of labor supplied
exceeds the quantity demanded.
Structural unemployment is often thought to explain longer spells of unemployment and Large scale
unemployment caused by low productive capacity. Unlike cyclical unemployment, structural unemployment
is of long-term nature; thus, reduction of structural unemployment requires expansion of productive capacity
which takes time.
D) Cyclical (Keynesian) unemployment

Under cyclical (Keynesian) unemployment:

 There is a cyclical relationship between demand, output, employment and unemployment
 Is caused by a fall in aggregate demand leading to a loss of real national output and employment
 A slowdown can lead to businesses laying off workers because they lack confidence that demand will
recover

Keynes argued that an economy can become stuck with a low rate of AD and an economy operating
persistently below its potential. Look at the graphs below; Y* representing full employment output level,
sometimes national output falls due to a fall in demand, this is called recession. Labor demand declines,
additional unemployment occurs to the extent of ee*. This is called cyclical unemployment.

In general,
– Short-run unemployment is the cyclical rate of unemployment and

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 – Long-run unemployment is the natural rate of unemployment

Natural Rate of Unemployment

The amount of unemployment that the economy normally experiences and does not go away on its own even
in the long run is called natural rate of unemployment. In other words, it is the long-run average or “steady
state” rate of unemployment. The labor market is in steady state, or in long-run equilibrium, if the
unemployment rate is constant.
Natural rate of unemployment is the average or long-run rate of unemployment around which the economy
fluctuates. In a recession, the actual unemployment rate rises above the natural rate. In a boom, the actual
unemployment rate falls below the natural rate.
Economists believe that such kind of unemployment is created when real wages are maintained above their
market clearing level leading to an excess supply of labour at the prevailing wage rate or if the national
minimum wage is set too high.

2.8.1.2 Solutions to unemployment

 boost aggregate demand e.g. increase government spending, build statues (creating jobs), reduce
taxes
 interest rates reduced: more investment, more money borrowed, more money spend, more jobs
 Supply side economics: train the workers make them more skilful. Also reduce taxes to increase
working incentives
 Lower the retirement ages/ raise school leaving age: it reduces unemployment however these
days is unlikely

2.8.2Inflation

There are two primary types of inflation: demand-pull and cost-push. Understanding which type of inflation is
occurring at any given point in time is important if policymakers want to respond appropriately. The two
types of inflation are not mutually exclusive, so it is possible for both to occur simultaneously. Left untreated,
inflation can cause a wage-price spiral or even hyperinflation.
2.8.2.1 Types and causes of inflation
The term inflation is usually used to indicate a rise in the general price level, though one can speak of
inflationary movements in any single price or group of prices.
The most important inflation is called demand-pull or excess demand inflation. It occurs when the total
demand for goods and services in an economy exceeds the available supply, so the prices for them rise in a
25
market economy. Historically this has been the most common type and at times the most serious. Every war
produces this type of inflation because demand for war materials and manpower grows rapidly without
comparable shrinkage elsewhere. Other types of inflation occur more readily in conjunction with demand-pull
inflation.
Another type of inflation is called cost-push inflation. The name suggests the cause--costs of production rise,
for one reason or another, and force up the prices of finished goods and services. Often a rise in wages in
excess of any gains in labor productivity is what raises unit costs of production and thus raises prices. This is
less common than demand-pull, but can occur independently as well as in conjunction with it.
A third type of inflation could be called pricing power inflation, but is more frequently called administered
price inflation. It occurs whenever businesses in general decide to boost their prices to increase their profit
margins. This does not occur normally in recessions but when the economy is booming and sales are strong. It
might be called oligopolistic inflation, because it is oligopolies that have the power to set their own prices and
raise them when they decide the time is ripe. One can at such times read in the newspapers that business is
just waiting a bit to see how soon they might raise their prices. An oligopolistic firm often realizes that if it
raises its prices, the other major firms in the industry will likely see that as a good time to widen their profit
margins too without suffering much from price competition from the few other firms in the industry.
The fourth type is called sectoral inflation. The term applies whenever any of the other three factors hits a
basic industry causing inflation there, and since the industry hit is a major supplier of many other industries,
as for example steel is, or oil is, that raises costs of the industries using say steel or oil, and forces up prices
there also, so inflation becomes more widespread throughout the economy, although it originated in just one
basic sector.
What sorts of policies might each type of inflation call for? Sectoral inflation takes us back to which of the
other 3 caused the inflation there.
For oligopolistic inflation, make sure there is no collusion which antitrust law makes illegal. It is likely not
possible to induce oligopolies to be more price competitive with each other, so the only way to get the benefit
of price competition to restrain oligopolistic inflation is to increase import competition if that is a possibility.

Since cost-push inflation is often wage increases exceeding increases in labor productivity, the problem is
whether it is possible or desirable to restrain such wage increases. The fact of the matter is, many wage rates
now leave the worker or the worker & family in poverty. It would be difficult to argue that those wages
should not rise to what is called a living wage level even though that may cause price increases for all who
already have higher incomes. But what about other wage earners. Should all of them, or all whose wages are
above average (but still below that of others) be restrained somehow from wage increases that exceed the

26
gains in their own labor productivity? If nobody else is restrained and profits are ballooning, would that be
fair?
Some European economies have wrestled with this problem more than others. They have sometimes come up
with what is called an incomes policy, essentially a bargain between business and labor that neither wages nor
profits shall gain more than the other for some agreed period, and that both shall be relatively restrained.
University of Minnesota economist Walter
Heller at one time proposed what he called wage-price guidelines for the same purpose, and others have
suggested tax policies to enforce such bargains between labor and business. Europe’s bargains often broke
down because business conditions improved and profits grew more than was in the bargain and labor refused
to restrain itself as much as originally agreed to. There is presently no agreed upon policy to deal with cost-
push inflation.

Demand pull inflation can appropriately and successfully be dealt with by a sufficiently aggressive macro-
economic policy: tight monetary and fiscal policies to cut out the excess demand. Tight money & high interest
rates to cut borrowing and slow or stop increases in the money supply, and running a government budget
surplus if necessary to reduce incomes and purchasing power. It is usually not employed vigorously enough to
do the job, but it always could be and stop this type of inflation. But if applied to any of the other types of
inflation it would likely create or increase unemployment and would not get at the root cause of that inflation.
Another angle to be mentioned is that these several types of inflation can all work at the same time. A familiar
term is a wage-price spiral, where demand pull likely starts inflation, labor demands and gets wage increases
to catch up to the rising cost of living, which increase their incomes and adds more demand-pull. That is a
good time for oligopolies to raise prices, and any of these hitting key sectors ads further inflation.

Such inflation can become cumulative and produces what is called hyperinflation or run-away inflation. Prices
may rise so fast that when labor gets paid it quits work and rushes to the stores to buy things needed before
their prices rise even further. At the extreme some countries with such inflation have in the end had to
repudiate their currency and start a new with money which they issue more sparingly to stop the inflation.
No one in their right mind would ever risk hyperinflation, so the problem is to know how much inflation can
be allowed without running the risk of hyperinflation. That will vary country by country and situation by
situation, and no one knows the answer anytime. So the risk should not be run.
But slow inflation does not pose the risk for this country. Inflation of 3% a year even increases business
profits and stimulates business because it buys materials and labor at one price level and by the time its
products are on the market they can be sold at a slightly higher price level.

27
The problem is to keep inflation from creeping upwards from that rate. And if it is continuous for a lifetime,
people who struggle to save as much as they can for retirement find that the purchasing power of their savings
is being reduced by 3% a year.
We will see in the next essay in this series that both inflation and inflation policies hurt somebody, so inflation
policy hangs upon decisions about who can best bear the effects of inflation and the effects of each anti-
inflation policy, and this involve an ethical judgment, not an economic judgment.

2.9The Relationship Between Inflation and Unemployment

 The Phillips Curve

The Phillips Curve is a graph depicting a relationship between unemployment rate and inflation rate.
The figure below shows a typical SHORT-RUN Phillips Curve.

• The implication of the negative slope is that the unemployment rate and the inflation rate are inversely
related - in other words, there is a trade-off between the two.

The LONG-RUN Phillips Curve

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• Earlier in this chapter, we discussed the natural rate of unemployment. It was defined to be fixed at a
point in the long-run, and it was shown that the economy tends to automatically return to that level on
its own.

• Then the long-run Phillips Curve must be a vertical line at the specific level of unemployment! If the
long-run Phillips Curve is vertical at a point like on the graph above, then policymakers must be able
to choose any inflation rate they desire along this line.

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