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Freshman Economics
INSTRUCTOR: ERMIYAS ABEBE
INTRODUCTION TO ECONOMICS
UNIT 6-PART 1
Fundamental Concepts of
Macroeconomics

Content

Chapter 6 Part 1
Fundamental Concepts of Macroeconomics

 Goals of macroeconomics
 The National Income Accounting
 Approaches to measure NI

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Goals of macroeconomics

 To achieve high economic growth

 To reduce unemployment
 To attain stable prices
 To reduce budget deficit and balance of payment (BoP) deficit
 To ensure fair distribution of income

The National Income Accounting

 National Income Accounting (NIA) is an accounting record of the

level of economic activities of an economy.
 It is a measure of an aggregate output, income and expenditure in an
economy.

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Approaches to measure national

income (GDP/GNP)
R1 B7 R4 B1 R7 B4

R2
Country B2
Country B5
R5
Red Blue
R3 B8 R6 B3 R8 B6

 GDP of Country Red = OUTPUT of (R1+R2+R3+R4+R5+R6+B7+B8)

 GNP of Country Red = OUTPUT of (R1+R2+R3+R4+R5+R6+R7+R8)
 GDP of Country Blue = OUTPUT of (B1+B2+B3+B4+B5+B6+R7+R8)
 GNP of Country Red = OUTPUT of (B1+B2+B3+B4+B5+B6+B7+B8)

Gross Domestic Product (GDP):

 It is the total value of currently produced final goods and services that are
produced within a country‘s boundary during a given period of time, usually
one year.
 It measures the current production only.
 It takes in to account final goods and services only
o We do not include the intermediate products in our GDP calculations.
o Intermediate goods are goods that are completely used up in the production of
other products in the same period that they themselves are produced.
 It measures the values of final goods and services produced within the
boundary/territory of a country irrespective of who owns that output.

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Double Counting

So count the final

product; which is
ONE CAR

Will make total

produced tyres 8 while
4 tyres + 1 car we have 4; Which is the
case of double counting
the tyres

Cont…

 In measuring GDP, we take the market values of goods and

services ( GDP =∑ PiQi ), where:
o Pi = series of prices of outputs produced in different sectors of an
economy in certain period
o Qi = the quantity of various final goods and services produced in an
economy

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Gross National Product (GNP):

 Is the total value of final goods and services currently produced by
domestically owned factors of production in a given period of
time, usually one year, irrespective of their geographical
locations.
 GDP and GNP are related as follows: GNP=GDP + NFI
 NFI denotes Net Factor Income received from abroad which is equal
to factor income received from abroad by a country‘s citizens less
factor income paid for foreigners to abroad.
 Thus, NFI could be negative, positive or zero depending on the
amount of factor income received by the two parties.

NFI= factor income received from abroad by a country‘s citizens less factor
income paid for foreigners to abroad

R1 B7 R4 B1 R7 B4

R2
Country B2
Country B5
R5
Red Blue
R3 B8 R6 B3 R8 B6

 NFI of Country Red = OUTPUT(Income paid) of (R7+R8)-(B7+B8)

 NFI of Country Blue = OUTPUT(Income Paid) of (B7+B8)-(R7+R8)

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GNP=GDP+NFI
 GDP of Country Red = OUTPUT of (R1+R2+R3+R4+R5+R6+B7+B8)
 GNP of Country Red = OUTPUT of (R1+R2+R3+R4+R5+R6+R7+R8)
 NFI of Country Red = OUTPUT(Income paid) of (R7+R8)-(B7+B8)

Proof of GNP=GDP+NFI= OUTPUT of (R1+R2+R3+R4+R5+R6+R7+R8)

 GDP+NFI= (R1+R2+R3+R4+R5+R6+(B7+B8)) + (R7+R8)-(B7+B8)
 GDP+NFI=(R1+R2+R3+R4+R5+R6+R7+R8)

GNP=GDP+NFI

GNP=GDP+NFI
NFI could be positive, negative or zero

 If NFI >0, then GNP > GDP

 If NFI< 0, then GNP < GDP
 If NFI =0, then GNP =GDP

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INTRODUCTION TO ECONOMICS
UNIT 6

PART-2

Approaches to Measure GDP/GNP

1. Product/Value Added Approach

Approaches to measure GDP/GNP

 Basically, there are three approaches to measure

GDP/GNP.
 These are:
1. Product/value added approach
2. Expenditure approach
3. Income approach

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Product
10 liters of Oil
10,000 birr

Expenditure Income
Households: 7,000 Workers: 1,500
Government: 2,000 Capital Owners: 2,000
Export: 1,000 Land Owners: 1,500
Import: 2,000 Business Owners: 5,000
=12,000-20000 =10,000
=10,000

1. Product Approach
 GDP is calculated by adding the market value of final goods and
services currently produced by each sector of the economy.
 There are two possible ways of avoiding double counting.
1. Taking only the value of final goods and services
2. Taking the sum of the valued added by all firms at each stage of
production

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 Taking only the value of final goods and services.

 Agriculture and allied activities = 9,309
 Agriculture = 7,000
 Forestry = 1,000
GDP = 9,309 + 147,413 + 357,872
 Fishing = 1,309
 Industry = 147,413
GDP = 514,594 million
 Mining & quarrying = 9,842
 Large & medium scale manufacturing = 91,852
 Electricity & water = 13,717 GNP = GDP + NFI
 Construction = 32,002 GNP = 514,594 + 87,348
 Service = 357,872
 Banking insurance and real estate = 121,704
GNP = 601,942 million
 Public administration & defense = 36,605
 Health = 20,000
 Education = 32,509
 Domestic & other services = 147,054
 Net factor income from abroad = 87,348

 Taking the sum of the valued added by all

firms at each stage of production

Stages of Values of Cost of Value added

production output (in birr) intermediate
inputs
Farmer 500 0 500
Oil factory 2000 500 1500
Retailers 2500 2000 500

So in GDP calculation we take final value at retail = 2500

or we take summation of values added = 2500

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INTRODUCTION TO ECONOMICS
UNIT 6

PART-3

Approaches to Measure GDP/GNP

2. Expenditure Approach

Product
10 liters of Oil
10,000 birr

Expenditure Income
Households: 7,000 Workers: 1,500
Government: 2,000 Capital Owners: 2,000
Export: 1,000 Land Owners: 1,500
Import: 2,000 Business Owners: 5,000
=12,000-20000 =10,000
=10,000

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2. Expenditure Approach
 GDP is measured by adding all expenditures on final goods and
services produced in the country by all sectors of the economy.
 GDP = C + I + G + NE
 C: Personal consumption of households
 I: Gross private domestic investment
 G: Government purchases of goods and services
 NE: Net exports

C: Personal consumption expenditure

 Expenditures by households on goods (durable and non-durable) and
services.
 Durable consumer goods: automobiles, refrigerators, video recorders, etc
 Non-durable consumer goods: clothes, shoes, pens, and services.

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I: Gross private domestic investment

 All spending of firms on plants, equipment, and inventories, and the
spending of households on new houses.
 Investment (Capital Creation) is broken down into three categories:
1. Residential investment: the spending of households on the
construction of new houses
2. Business fixed investment: the spending of firms on buildings and
equipment for business use
3. Inventory investment: the change in inventories of firms

Note!
 Gross private domestic investment differs from net private
domestic investment
 Gross includes both replacement and added investment whereas
the Net refers only to added investment.
 Replacement means the production of all investment goods,
which replace machinery, equipment and buildings used up in
the production process.
 In short, net private domestic investment = gross private
domestic investment minus depreciation.

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G: Government purchases
 All government spending on finished products and direct purchases
of resources less (minus) government transfer payments (because
they do not reflect current production although they are part of
government expenditure)
 Transfer payments are excluded from GDP, as these are mere
redistribution of income from taxpayers to the recipients of transfer
payments.
e.g. old age pension, unemployment benefit, subsidies, etc

NE: Net exports

 Refer to total value of exports less total value of imports.

Note!
 Net export (EX-IM) is different from the terms of trade (EX/IM)

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Example: GDP at current market price measured using

expenditure approach for a hypothetical economy.
Types of Expenditure Amount (in million Birr)
1. Personal consumption expenditure 4500
Durable consumer goods 1500
Non-durable consumer goods 2000
Services 1000
2. Gross private domestic investment 600
Business fixed investment 250
Construction Expenditure 300
Increases in inventories 50
3. Government expenditure on goods and services 250
Federal government 100
State government 150
4. Net export -50
Exports 150
Imports 200
GDP at current market price 5300

INTRODUCTION TO ECONOMICS
UNIT 6

PART-4

Approaches to Measure GDP/GNP

3. Income Approach

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Product
10 liters of Oil
10,000 birr

Expenditure Income
Households: 7,000 Workers: 1,500
Government: 2,000 Capital Owners: 2,000
Export: 1,000 Land Owners: 1,500
Import: 2,000 Business Owners: 5,000
=12,000-20000 =10,000
=10,000

3. Income Approach
 GDP is calculated by adding all the incomes accruing to all factors
of production used in producing the national output.
 Land-Rent
 Labor-Wage & Salary
 Capital-Interest
 Management-Profit
 GDP is the sum incomes to owners of factors of production plus
some other claims on the value of output (depreciation and indirect
business tax) less subsidies and transfer payments

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Note!
 Transfer payments:
 Payments which are made to the recipients who have not contributed
to the production of current goods and services in exchange for
these payments
 Are excluded from national income, as these are mere redistribution
of income from taxpayers to the recipients of transfer payments.
e.g. old age pension, unemployment benefit, subsidies, etc

GDP =
 Compensation of employees (wages & salaries )
+ Rental Income
+ Interest Income
+ Profits (proprietors’ profit plus corporate profit)
+ Indirect business taxes
+ Depreciation
- Subsidies
- Transfer payments

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Example: GDP at current market price measured using income

approach for a hypothetical economy.
Items Value (In millions of Birr)
Compensation of Employees (plus) 45623.71
Rental Income (plus) 1249.32
Proprietor‘s Income (plus) 10561.21
Corporate Profits (plus) 16960.33
Net interest (plus) 5189.73
Depreciation (plus) 503.84
Indirect Business Taxes (plus) 476.51
Subsidy (minus) 11368.95
Gross Domestic Product 69,195.70
(plus) NFI Income from abroad (plus) 2036.20
Payments to abroad (minus) 11231.90
Gross National Product(Income) 60,000.00

INTRODUCTION TO ECONOMICS
UNIT 6
Part-5
Other Income Accounts
1. Net National Product (NNP)
2. National Income (NI)
3. Personal Income (PI)
4. Personal Disposable Income (PDI)

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Previous Part: Income Approach to GDP/GNI

Items Value (In millions of Birr)
Compensation of Employees (plus) 45623.71
Rental Income (plus) 1249.32
Proprietor‘s Income (plus) 10561.21
Corporate Profits (plus) 16960.33
Net interest (plus) 5189.73
Depreciation (plus) 503.84
Indirect Business Taxes (plus) 476.51
Subsidy (minus) 11368.95
Gross Domestic Product 69,195.70
(plus) NFI Income from abroad (plus) 2036.20
Payments to abroad (minus) 11231.90
Gross National Product(Income) 60,000.00

1. Net National Product (NNP)

 GNP fails to take into account capital consumption allowance, which
is necessary to replace the capital goods used up in that year‘s
production.

Net National product (NNP) =Gross National product (GNP) – Capital

consumption allowance (D)

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Net National Product (NNP)

Items Value (In millions of Birr)

Compensation of Employees (plus) 45623.71

Rental Income (plus) 1249.32
Proprietor‘s Income (plus) 10561.21
Corporate Profits (plus) 16960.33
Net interest (plus) 5189.73
Depreciation (plus) 503.84
Indirect Business Taxes (plus) 476.51
Subsidy (minus) 11368.95
Gross Domestic Product 69,195.70
(plus) NFI Income from abroad (plus) 2036.20
Payments to abroad (minus) 11231.90
Gross National Product(Income) 60,000.00
Net National product (NNP) 59,496.16

2. 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 are involved in the given year‘s
production activity.
 From NNP, indirect business tax, which is collected by the
government, does not reflect the productive contributions of
economic resources because government contributes nothing.

National Income (NI) = Net National Product (NNP)– Indirect

Business Tax (IBT)

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National Income (NI)

Items Value (In millions of Birr)

Compensation of Employees (plus) 45623.71

Rental Income (plus) 1249.32
Proprietor‘s Income (plus) 10561.21
Corporate Profits (plus) 16960.33
Net interest (plus) 5189.73
Depreciation (plus) 503.84
Indirect Business Taxes (plus) 476.51
Subsidy (minus) 11368.95
Gross Domestic Product 69,195.70
(plus) NFI Income from abroad (plus) 2036.20
Payments to abroad (minus) 11231.90
Gross National Product(Income) 60,000.00
Net National product (NNP) 59,496.16
National income (NI) 59,019.65

3. Personal Income (PI)

 It refers to income earned by persons or households.
 Persons in the economy may not earn all the income earned as national
income.

PI = NI
– [social security contribution + corporate income tax + retained corporate profit]
+ [Public transfer payments (e.g. Subsidy) + net interest on government bond]

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4. Personal Disposable Income

 it is personal income less personal tax payments.

DI = PI – Personal taxes
DI = C + S
where, C = personal consumption expenditure, S =
Personal saving

Connection of All Income Accounts

- Indirect Business Tax

- Personal Tax
+ NFI

GDP GNP NNP NI PI PDI= C+S

- (social security contribution + corporate

- Depreciation income tax + retained corporate profit)
+ (Public transfer payments (e.g. Subsidy)
+ net interest on government bond)

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INTRODUCTION TO ECONOMICS
UNIT 6
Part-6
Nominal Vs Real GDP

Nominal GDP
 Is the value of all final goods and services produced in a given year
when valued at the prices of that year.
 Given that GDP= PXQ, any change that can happen in the country ‘s
GDP is due to changes in price, quantity or both.
 For example, if prices are doubled over one year, then GDP will also
double even though exactly the same goods and services are produced
as the year before.
 Hence, GDP that is not adjusted for inflation is called Nominal GDP.

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Real GDP
 Real GDP is the value of final goods and services produced in
a given year when valued at the prices of a reference base year.

 By comparing the value of production in the two years at the

same prices, we reveal the change in output.

 Hence, to be able to make reasonable comparisons of GDP

overtime we adjust for inflation.

Example: Nominal and Real GDP Calculations

Year Product Quantity Price Nominal GDP Real GDP

Produced

2013 X 20 5
(Base Year) (20x5)+(8x50) (20x5)+(8x50)
Y 8 50 =500 =500

2014 X 25 20
(25x20)+(10x100) (25x5)+(10x50)
Y 10 100 =1,500 =625

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INTRODUCTION TO ECONOMICS
UNIT 6
Part-7
The GDP Deflator and the Consumer
Price Index(CPI)

The GDP Deflator

 The calculation of real GDP gives us a useful measure of inflation
known as the GDP deflator.
 It reflects what‘s happening to the overall level of prices in the
economy.
 The GDP deflator is the ratio of nominal GDP in a given year to
real GDP of that year.
𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏
GDP Deflator = * 100
𝐑𝐞𝐚𝐥 𝐆𝐃𝐏

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From Part-6 Example: we have Nominal and Real

GDP Values. Now lets calculate GDP Deflator.
Year Nominal Real GDP Deflator
GDP GDP (𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏
𝐑𝐞𝐚𝐥 𝐆𝐃𝐏
* 100)

2013 500 500 𝟓𝟎𝟎

(𝟓𝟎𝟎 * 100) = 100
(Base Year)
2014 1,500 625 𝟏𝟓𝟎𝟎
( 𝟔𝟐𝟓 * 100) = 240
 For 2013 (base year), as both the real and nominal GDP values are exactly the same,
the GDP deflator in the base year is always 100.
 For 2014, GDP Deflator of 240 shows the price in 2018 was 140% higher than the
price in base year

The Consumer Price Index (CPI)

 CPI is an indicator that measures the average change in prices paid by consumers
for a representative basket of goods and services.
 It compares the current and base year cost of a basket of goods of fixed
composition.
 The CPI is the ratio of today's cost to the base year cost.
• Given base year quantities q'0 and base year prices р'0, cost of the basket in the
base year is ∑(р'0*q'0),
• Given today's price (pt), the cost of a basket of the same quantities q'0 at today's
prices is ∑(p't*q'0).
𝐓𝐨𝐝𝐚𝐲 ′ 𝐬 𝐂𝐨𝐬𝐭 ∑(р′0∗q′0)
CPI = =
𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫 𝐂𝐨𝐬𝐭 ∑(p′t∗q′0)

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The CPI versus the GDP Deflator

SN GDP Deflator CPI
1 • Measures the prices of all goods and services • Measures the prices of only the
produced (an increase in the price of goods goods and services bought by
bought by firms or the government will show consumers.
up in the GDP deflator)
2 • Includes only those goods produced • Includes both domestically
domestically (Imported goods are not part of produced and imported goods
GDP and do not show up in the GDP deflator)
3 • Assigns changing weights (allows the basket of • Assigns fixed weights to the prices
goods to change over time as the composition of different goods (it is computed
of GDP changes) using a fixed basket of goods)

INTRODUCTION TO ECONOMICS
UNIT 6
Part-8
The Business Cycle

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The Business Cycle

 Business cycle refers to the recurrent ups and downs in the level of economic
activity.
 A business cycle is a fluctuation in overall economic activity, which is characterized
by the simultaneous expansion or contraction of output in most sectors.
 Countries usually experience ups and downs in the level of total output and
employment over time.
 With the fluctuation in the overall economic activity, the level of unemployment
also moves up and down.
 We can identify four phases in the business cycle; Boom/peak,
Recession/contraction, Trough/Depression, and Recovery/Expansion

Note!
 One business cycle includes the point from one peak to the
next peak or from one trough to the next.
A business cycle is a short-term fluctuation in economic
activities.
 The trend path of GDP is the path GDP would take if
factors of production were fully employed.
 Business cycles may vary in duration and intensity.

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The Business Cycle

Real Cycle 1 Cycle 2 Peak

GDP Peak Growth

Trend

Expansion
Recession
Peak

Expansion

Recession Trough

Trough

Time

Boom/peak

• Highest level of output in the business cycle.

• End of economic expansion and the beginning of recession.
• In this phase, the economy‘s output is growing faster than its long-
term (potential) trend and is therefore unsustainable.
• Due to very high degree of utilization of resources, unemployment
level is low; business is good; and it is a period of prosperity.

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Recession/contraction

• Level of economic performance generally declines.

• Total output declines, national income falls, and business
generally decline.
• Unemployment problem rises.
• This period can cause hardship on business and citizens.

Trough/Depression:

• When the recession becomes particularly severe, we say the

economy reaches depression or trough. The lowest point in a
business cycle.
• End of a recession and the beginning of economic
recovery/expansion.
• During this period, there is an excessive amount of unemployment
and idle productive capacity.

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Recovery/Expansion:
• The economy starts to grow or recover, i.e. there is an
option of economic activity between a trough and a peak.
• More and more resources are employed in the production
process; output increases, unemployment level diminishes
and national income rises.
• When this expansion of the economy reaches its maximum,
the economy once again comes to another boom or peak

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