CHAPTER TWO

2. NATIONAL INCOME ACCOUNTING

Measurement is a crucial part of scientific study. Accurate measurement is essential for making
new discoveries, evaluating competing theories, and predicting future events or trends.
Some conceptual and practical issues involved in measuring the macro economy will be discussed
in this chapter. We focus on the NATIONAL INCOME ACCOUNTS, a framework for measuring
economic activity that is widely used by economic researchers and analysts. National Income
Accounting is an accounting record of the level of economic performance of an economy. It is a
measure of aggregate output, income and expenditure in an economy.

Learning about the national income accounts will familiarize you with some useful economic data.
In addition, because the national income accounts are set up in a logical way that mirrors the
structure of the economy, working through these accounts is an important first step toward
understanding how the macro economy works. When you finish this chapter, you will have a clearer
understanding of the relationships that exist among key macroeconomic variables and among
the different sectors of the economy.

2.1 The concepts of GDP and GNP

Gross domestic product (GDP) is defined as the market value of final goods and services newly
produced within a nation during a fixed period of time (usually a year). Gross national product
(GNP/GNI) is the market value of final goods and services newly produced by domestic factors of
production during the current period (as opposed to production taking place within a country, which
is GDP).
The key difference between the two is that GDP is the total output of a country/region, and GNP is
the total output of all nationals of a country/region.

GNP= GDP + Net factor income (NFI)/net factor payment (NFP), where NFI is the income
received by domestic factors of production (Capital and labor) employed abroad minus the income
paid to foreigners employed domestically.

Example: Consider GDP and GNP of a hypothetical country

National income and output (Billions of dollars) Period Ending 2003

Net income receipts from rest of the world 55.2

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 income receipts 329.1
income payments 273.9
Gross domestic product 11,004.1
Gross national Income 11059.3

Q: What happens to the value of GNP/GDP when there is brain drain for a country?

2.2 Approaches of measuring national income (GDP/GNP)

There are three main ways of calculating these numbers; the output approach, the income
approach and the expenditure approach. In theory, the three must yield the same, because total
expenditures on goods and services (GNE) must equal the total income paid to the producers (GNI),
and that must also equal the total value of the output of goods and services (GNP).

However, in practice minor differences are obtained from the various methods for several reasons,
including changes in inventory levels and errors in the statistics. This is because goods in
inventory have been produced (therefore included in GNP), but not yet sold (therefore not yet
included in GNE). Similar timing issues can also cause a slight discrepancy between the value of
goods produced (GNP) and the payments to the factors that produced the goods, particularly if
inputs are purchased on credit, and also because wages are collected often after a period of
production.
A. The Output approach (final goods vs. the value added) to measuring GDP

The product approach defines a nation's gross domestic product (GDP) as the market value of final
goods and services newly produced within a nation during a fixed period of time. In working
through the various parts of this definition, we discuss some practical issues that arise in measuring
GDP.
i. Market Value: Goods and services are counted in GDP at their market values- that is, at the
prices at which they are sold. The advantage of using market values is that it allows adding the
production of different goods and services.
Using market values to measure production makes sense because it takes into account differences in
the relative economic importance of different goods and services. A problem with using market
values to measure GDP is that some useful goods and services are not sold in formal markets.
Ideally, GDP should be adjusted upward to reflect the existence of these goods and services.
However because of the difficulty of obtaining reliable measures, some non-market goods and
services simply are ignored in the calculation of GDP. Homemaking and child-rearing services
performed within the family without pay, for example, are not included in GDP, although

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 homemaking and child care that are provided for pay (for example, by professional housecleaners
or by private day-care centers) are included. Similarly, because the benefits of clean air and water
aren't bought and sold in markets, actions to reduce pollution or otherwise improve environmental
quality usually are not reflected in GDP.
Some nonmarket goods and services are partially incorporated in official GDP measures. An
example is activities that take place in the so-called underground economy. The underground
economy includes both legal activities hidden from government record keepers (to avoid payment
of taxes or compliance 'with regulations, for example) and illegal activities such as drug dealing,
prostitution, and (in some places) gambling. Some might argue that activities such as drug dealing
are "bads" rather than "goods" and shouldn't be included in GDP anyway -although a consistent
application of this argument might rule out many goods and services currently included in GDP.
Government statisticians regularly adjust GDP figures to include estimates of the underground
economy's size.

A particularly important component of economic activity that does not pass through markets is the
value of the services provided by government, such as defense, public education, and the building
and maintenance of roads and bridges. The fact that most government services are not sold in
markets implies a lack of market values to use when calculating the government's contribution to
GDP. In this case the solution that has been adopted is to value government services at their cost of
production. Thus the contribution of national defense to GDP equals the government's cost of
providing defense: the salaries of service and civilian personnel, the costs of building and
maintaining weapons and bases, and so on. Similarly, the contribution of public education to GDP
is measured by the cost of teachers' salaries, new schools and equipment, and so on.
ii. Newly Produced Goods and Services: As a measure of current economic activity, GDP includes
only goods or services that are newly produced within the current period. GDP excludes purchases
or sales of goods that were produced in previous periods. Thus, although the market price paid for a
newly constructed house would be included in GDP, the price paid in the sale of a used house is not
counted in GDP (The value of the used house would have been included in GDP for the year it was
built). However, the value of the services of the real estate agent involved in the sale of the used
house is part of GDP, because those services are provided in the current period.

iii. Final Goods and Services: Goods and services produced during a period of time may be classified
as either intermediate goods and services or final goods and services. Intermediate goods and
services are those used up in the production of other goods and services. Intermediate goods and

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services are those used up in the production other goods and services in the same period that they
themselves were produced. For example, flour that is produced and then used to make bread in the
same year is an intermediate good. The trucking company that delivers the flour to the bakery
provides an intermediate service.
An alternative to considering the value of final goods and services in the calculation is by counting
only the values at each stage of production. Using either of these methods avoids an issue often
called 'double counting', wherein the total value of a good is included several times in national
output, by counting it repeatedly in several stages of production. In the example of meat production,
the value of the good from the farm may be $10, then $30 from the butchers, and then $60 from the
supermarket. The value that should be included in final national output should be $60, not the sum
of all those numbers, $100. The values added at each stage of production over the previous stage are
respectively $10, $20, and $30. Their sum gives an alternative way of calculating the value of final
output.

B. The expenditure approach

A different perspective on the components of GDP is obtained by looking at the expenditure side of
the national income accounts. The expenditure approach measures GDP as total spending on final
goods and services produced within a nation during a specified period of time. Four major
categories of spending are added to get GDP: consumption, investment, government purchases of
goods and services, and net exports of goods and services. In symbols,
Y = GDP = total production (or output)
= total income
= total expenditure;
C = consumption;
I = investment;
G = government purchases of goods and services;
NX = net exports of goods and services
With these symbols, we express the expenditure approach to measuring GDP as

y = C + I + G + NX

1. Consumption: Consumption is spending by domestic households on final goods and services,

including those produced abroad. It is the largest component of expenditure, usually accounting
for about two-thirds of GDP in most countries. Consumption expenditures are grouped into
three categories:
 Consumer durables, which are long-lived consumer items, such as cars, televisions,
furniture, and major appliances (but not houses, which are classified under investment);
 Non-durable goods, which are shorter-lived items, such as food, clothing, and fuel; and
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  Services, such as education, health care, financial services, and transportation
2. Investment: Investment includes both spending for new capital goods, called fixed investment,
and increases in firms' inventory holdings, called inventory investment. Fixed investment in
turn has two major components:
 Business fixed investment, which is spending by businesses on structures (factories,
warehouses, and office buildings, for example) and equipment (such as machines, vehicles,
and furniture); and
 Residential Investment, which is spending on the construction of new houses apartment
buildings. Houses and apartment buildings are treated as residential goods because they
provide a service or shelter over a long period of time.

As we have mentioned, increases in inventories are included in investment spending, regardless of

why inventories rose. In particular, if a firm produces goods that it can't sell, the resulting rise in
inventories counts as investment by the firm. For the purposes of national income accounting, the
firm has, in effect, purchased the unsold goods from itself. This accounting rule is useful because it
guarantees that production and expenditure will always be equal in the national income accounts.
Anything that is produced must, by definition, either be bought by a customer or "purchased" by the
firm itself.
3. Government Purchases of Goods and Services:
Government purchases of goods and services, which include any expenditure by the government for
a currently produced good or service, foreign or domestic, is the third major component of
spending.
Not all the checks written by the government are for purchases of goods and services. Transfers, a
category that includes government payments for Social Security and Medicare benefits,
unemployment insurance, welfare payments, and so on, are payments (primarily to individuals) by
the government that are not made in exchange for current goods or services. As a result, they are
excluded from the government purchases category and are not counted in GDP as calculated by the
expenditure approach. Similarly, interest payments on the national debt are not counted as part of
government purchases.
Much like the distinction between private-sector consumption and investment, some part of
government purchases goes toward current needs (such as employee salaries) and some is devoted
to acquiring capital goods (such as office buildings).
4. Net Exports

Net exports are exports minus imports. Exports are the goods and services produced within a
country that are purchased by foreigners; imports are the goods and services produced abroad that
are purchased by a country's residents. Net exports are positive if exports are greater than imports
and negative if imports exceed exports. Exports are added to total spending because they represent
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 spending (by foreigners) on final goods and services produced in a country. Imports are subtracted
from total spending because consumption, investment, and government purchases are defined to
include imported goods and services. Subtracting imports ensures that total spending, C + I + G +
NX, reflects spending only on output produced in the country. For example, an increase in imports
may mean that Americans are buying Japanese cars instead of American cars. For fixed total
spending by domestic residents, therefore, an increase in imports lowers spending on domestic
production.

C. The Income Approach to Measuring GDP

This approach calculates GDP by adding the incomes received by producers, including profits, and
taxes paid to the government. A key part of the income approach is a concept known as national
income. National income is the sum of five types of income.
i. Compensation of employees: Compensation of employees is the income of workers (excluding the
self-employed) and includes wages, salaries, employee benefits (including contributions by
employers to pension plans), and employer contributions to Social Security.
ii. Proprietors’’ income: Proprietors' income is the income of the non- incorporated self-employed.
Because many self-employed people own some capital (examples are a farmer's tractor or a dentist's
X-ray machine), proprietors’' income includes both labor income and capital income.
iii. Rental income: Rental income of persons, a small item, is the income earned by individuals who
own land or structures that they lent to others. Some miscellaneous types of income, such as royalty
income paid to authors, recording artists, and others, also are included in this category.
iv. Corporate profits: corporate profits are the profits earned by corporations and represent the
remainder of corporate revenue after wages, interest, rents, and other costs have been paid. Corporate
profits are used to pay taxes levied on corporations, such as the corporate income tax, and to pay
dividends to shareholders. The rest of corporate profits after taxes and dividends, called retained
earnings, are kept by the corporation.
v. Net interest: Net interest is interest earned by individuals from businesses and foreign sources
minus interest paid by individuals.
In addition to the five components of national income just described, three other items need to be
accounted for to obtain CDP:
 indirect business taxes;
 depreciation; and
 net factor payments

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Indirect business taxes, such as sales and excise taxes are paid by businesses to governments.
Indirect business taxes do not appear in any of the five categories of income discussed, but because
they are income to the government, they must be added to national income to measure all of a
country's income. National income plus indirect business taxes equal net national product (NNP).

Depreciation (also known as consumption of fixed capital) is the value of the capital that wears out
during the period over which economic activity is being measured. In the calculation of the
components of national income (specifically, Proprietors' income, corporate profits, and rental
income), depreciation is subtracted from total, or gross, income. Thus, to compute the total or gloss
amount of income, we must add back in depreciation. The sum of net national product and
depreciation is gross national product (GNP). Gross national product and gross domestic product
are called gross because they measure the nation's total production or output of goods and services
without subtracting depreciation.

As we discussed earlier, to go from GNP to GDP we have to subtract net factor payments or net
factor income from abroad, NFP/NFI.

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

The national income accounts include other measures of income that differ slightly in definition
from GDP. It is important to be aware of the various measures, because economists and the press
often refer to them.
To see how the alternative measures of income relate to one another, we start with GDP and add
or subtract various quantities. To obtain gross national product (GNP), we add receipts of factor
income (wages, profit, and rent) from the rest of the world and subtract payments of factor income
to the rest of the world:
GNP = GDP + Factor Payments From Abroad - Factor Payments to Abroad.
Whereas GDP measures the total income produced domestically, GNP measures the total income
earned by nationals (residents of a nation). For instance, if a Japanese resident owns an apartment
building in New York, the rental income he earns is part of U.S. GDP because it is earned in the
United States. But because this rental income is a factor payment to abroad, it is not part of
U.S.GNP. This income is included in the Japan’s GNP and should be subtracted from the Japan’s
GDP.

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To obtain net national product (NNP), we subtract the depreciation of capital—the amount of the
economy’s stock of plants, equipment, and residential structures that wears out during the year:
NNP = GNP - Depreciation
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 1, such as excise
tax, and sales taxes. These taxes place a wedge between the price that consumers pay for a good and
the price that firms receive. Because firms never receive this tax wedge, it is not part of their
income. Once we subtract indirect business taxes from NNP, we obtain a measure called national
income:
National Income (NI) = NNP-Indirect Business Taxes
National income measures how much everyone in the economy has earned. The national income
accounts divide national income into five components, depending on the way the income is earned.
The five categories are:
➤ Compensation of employees: The wages and fringe benefits earned by workers.
➤ Proprietors’ income: The income of non-corporate businesses, such as small farms, mom-and-
pop stores, and law partnerships.
➤ Rental income: The income that landlords receive, including the imputed rent that homeowners
―pay’’ to themselves, less expenses, such as depreciation.
➤ Corporate profits: The income of corporations after payments to their workers and creditors.
➤ Net interest: The interest domestic businesses pay minus the interest they receive, plus interest
earned from foreigners.
A series of adjustments takes us from national income to personal income, the amount of income
that households and non-corporate businesses receive. Three of these adjustments are most

1
An excise is considered an indirect tax, meaning that the producer or seller who pays the tax to the
government is expected to try to recover or shift the tax by raising the price paid by the buyer. Excises are
typically imposed in addition to another indirect tax such as a sales tax or value added tax (VAT). In common
terminology (but not necessarily in law), an excise is distinguished from a sales tax or VAT in three ways: (i)
an excise typically applies to a narrower range of products; (ii) an excise is typically heavier, accounting for a
higher fraction of the retail price of the targeted products; and (iii) an excise is typically a per unit tax, costing
a specific amount for a volume or unit of the item purchased, whereas a sales tax or VAT is an ad valorem
tax and proportional to the price of the good.

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important. First, we reduce national income by the amount that corporations earn but do not pay
out, either because the corporations are retaining earnings or because they are paying taxes to the
government. This adjustment is made by subtracting corporate profits (which equals the sum of
corporate taxes, dividends, and retained earnings) and adding back dividends. 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.) Thus, personal income is
Personal Income = National Income
− Corporate Profits
− Social Insurance Contributions2
− Net Interest
+ Dividends
+ Government Transfers to Individuals
+ Personal Interest Income

Next, if we subtract personal tax payments and certain nontax payments to the government (such as
parking tickets), we obtain disposable personal income:
Disposable Personal Income= Personal Income- Personal Tax and Nontax Payments
We are interested in disposable personal income because it is the amount households and non-
corporate businesses have available to spend after satisfying their tax obligations to the government.
2.4 Nominal 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 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,
GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges).

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

2
People receive benefits or services in recognition of contributions to an insurance program. These
services typically include provision for retirement pensions, disability insurance, survivor benefits
and unemployment insurance.

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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 nominal GDP.

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 2002 and output in
2003 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 2002. Goods and services are then added up using
these base-year prices to value the different goods in both years. Real GDP for 2002 would be
Real GDP = (2002 Price of Apples × 2002 Quantity of Apples) + (2002 Price of Oranges × 2002
Quantity of Oranges).
Similarly, real GDP in 2003 would be
Real GDP = (2002 Price of Apples × 2003 Quantity of Apples) + (2002 Price of Oranges × 2003
Quantity of Oranges).
And real GDP in 2004 would be
Real GDP = (2002 Price of Apples × 2004 Quantity of Apples) + (2002 Price of Oranges × 2004
Quantity of Oranges).
Notice that 2002 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.

2.5 The GDP Deflator and the Consumer Price Index

A. GDP Deflator
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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, bread. If P is the price of
bread and Q is the quantity sold, then nominal GDP is the total number of dollars spent on bread in
that year, P × Q. Real GDP is the number of loaves of bread produced in that year times the price of
bread in some base year, Pbase × Q. The GDP deflator is the price of bread in that year relative to
the price of bread in the base year, P/Pbase. 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. We can also write this equation as
Real GDP = Nominal GDP/GDP Deflator
In this form, you can see how the deflator earns its name: it is used to deflate (that is, take inflation
out of) nominal GDP to yield real GDP.
Q: Do you think that measuring the real GDP using GDP deflator which uses base year prices
for long time is appropriate?

We have been discussing real GDP as if the prices used to compute this measure never change from
their base-year values. If this were truly the case, over time the prices would become more and
more 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. With chain-weighted
measures of real GDP, the base year changes continuously over time. In essence, average prices in
2001 and 2002 are used to measure real growth from 2001 to 2002; average prices in 2002 and 2003
are used to measure real growth from 2002 to 2003; and so on. These various year-to-year growth
rates are then put together to form a ―chain‖ that can be used to compare the output of goods and
services between any two dates.
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,

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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.
B. The consumer Price Index (CPI)
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 is determined by using price
indexes. One of these indexes is the consumer price index (CPI)
CPI is a price index of a particular basket called the CPI-basket. The CPI –basket contains basically
all the goods and services consumed in a country-food, gas, medicine, haircuts, transportation,
house rent and so on. The composition of the CPI basket is determined by the value of what is
consumed in the country-the larger the value of total consumption of a good or service, the larger
the weight in the basket. The exact details of the composition of the basket and how the CPI is
calculated are complicated and vary somewhat between countries. Calculation of the CPI needs a
reference or base year for which the CPI is exactly 100 on average.
Q: How economists measure changes in the cost of living?
The most commonly used measure of the level of prices is the consumer price index (CPI). 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.
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 a
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 × Current Price of Apples) + (2 × Current Price of Oranges)

(5 × 2002 Price of Apples) + (2 × 2002 Price of Oranges)
In this CPI, 2002 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 2002.

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 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 indices, the Bureau of
Labor Statistics computes price indices for specific types of goods, such as food, housing, and
energy.
Q: What is the difference between GDP deflator and the CPI?

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.
i. GDP deflator measures the prices of all goods and services produced, whereas the CPI measures the
prices of only the goods and services bought by consumers. Thus, an increase in the price of goods
bought by firms or the government will show up in the GDP deflator but not in the CPI.
ii. 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.
iii. The third and most subtle difference results from the way the two measures aggregate the many
prices in the economy. The CPI assigns fixed weights to the prices of different goods, whereas the
GDP deflator assigns changing weights. In other words, the CPI is computed using a fixed basket
of goods, whereas the GDP deflator allows the basket of goods to change over time as the
composition of GDP changes.

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.
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. Economic theorists have studied the properties of these
different types of price indices to determine which a better measure of the cost of living is. The
answer, it turns out, is that neither is clearly superior. When prices of different goods are changing
by different amounts, a Laspeyres (fixed basket) index tends to overstate the increase in the cost of
living because it does not take into account that consumers have the opportunity to substitute less
expensive goods for more expensive ones. By contrast, a Paasche (changing basket) index tends to
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understate the increase in the cost of living. Although it accounts for the substitution of alternative
goods, it does not reflect the reduction in consumers’ welfare that may result from such
substitutions.
The example of the destroyed orange crop shows the problems with Laspeyres and Paasche price
indices. Because the CPI is a Laspeyres index, it overstates the impact of the increase in orange
prices on consumers: by using a fixed basket of goods, it ignores consumers’ ability to substitute
apples for oranges. By contrast, because the GDP deflator is a Paasche index, it understates the
impact on consumers: the GDP deflator shows no rise in prices, yet surely the higher price of
oranges makes consumers worse off.
Luckily, the difference between the GDP deflator and the CPI is usually not large in practice.

2.6 GDP and Welfare

GDP per capita (per person) is often used as a measure of a person's welfare. Countries with higher
GDP may be more likely to also score highly on other measures of welfare, such as life expectancy.
However, there are serious limitations to the usefulness of GDP as a measure of welfare:

 Measures of GDP typically exclude unpaid economic activity, most importantly domestic
work such as childcare. This leads to distortions; for example, a paid nanny's income
contributes to GDP, but an unpaid parent's time spent caring for children will not, even though
they are both carrying out the same economic activity.
 GDP takes no account of the inputs used to produce the output. For example, if everyone
worked for twice the number of hours, then GDP might roughly double, but this does not
necessarily mean that workers are better off as they would have less leisure time. Similarly, the
impact of economic activity on the environment is not measured in calculating GDP.
 Comparison of GDP from one country to another may be distorted by movements in exchange
rates. Measuring national income at purchasing power parity may overcome this problem at the
risk of overvaluing basic goods and services, for example subsistence farming.
 GDP does not measure factors that affect quality of life, such as the quality of the
environment (as distinct from the input value) and security from crime. This leads to distortions
- for example, spending on cleaning up an oil spill is included in GDP, but the negative impact
of the spill on well-being (e.g. loss of clean beaches) is not measured.
 GDP is the mean (average) wealth rather than median (middle-point) wealth. Countries with
a skewed income distribution may have a relatively high per-capita GDP while the majority of

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 its citizens have a relatively low level of income, due to concentration of wealth in the hands of
a small fraction of the population.

2.7. The Business Cycle

The business cycle refers to the period of upward (expansions/boom in periods of relatively rapid
economic growth) and downward (contractions/recessions in periods of stagnation or decline)
movements in the level of economic activities (GDP) around its long-term growth trend.

Inflation, growth, and unemployment are related through the business cycle. At a cyclical peak,
economic activity is high relative to trend; and at a cyclical trough, the low point in economic
activity is reached. Inflation, growth, and unemployment all have clear cyclical patterns.

Figure 1: Business cycle

Output Peak
Trend

Trough

Time

The trend path of GDP is the path GDP would take if factors of production were fully employed.
Over time, real GDP changes for two reasons. First, more resources become available which
allows the economy to produce more goods and services, resulting in a rising trend level of output.
Second, factors are not fully employed all the time. Thus, output can be increased by increasing
capacity utilization.

Output is not always at its trend level, that is, the level corresponding to full employment of the
factors of production. Rather output fluctuates around the trend level. During expansion (or
recovery) the employment of factors of production increased, and that is a source of increased
production. Conversely, during a recession unemployment increases and less output is produced
than can in fact be produced with the existing resources and technology. Deviations of output
from trend are referred to as the output gap.
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 The output gap measures the gap between actual output and the output the economy could produce
at full employment given the existing resources. Full employment output is also called potential
output.
– actual output
When looking at the business cycle fluctuation, one question that naturally arises is whether
expansions give way inevitably to old age, or whether they are instead brought to an end by policy
mistakes. Often a long expansion reduces unemployment too much; causes inflationary pressures,
and therefore triggers policies to fight inflation- and such policies usually create recessions.
Okun’s Law
A relationship between real growth and changes in the unemployment rate is known as Okun’s law,
named after its discoverer, Arthur Okun. Okun’s law says that the unemployment rate declines when
growth is above the trend rate.
-x(ya – yt)
Where
percentage point growth, ya actual growth rate of output, and yt is trend output growth rate.
The figure below shows the Okun’s law, relationship between unemployment and growth in output.
12 Growth and Unemployment Dynamics
Percentage change in real GDP

0
-3 -2 -1 0 1 2 3
Change in unemployment rate
-3

2.8. Unemployment and Inflation

2.8.1. Unemployment
One aspect of economic performance is how well an economy uses its resources. Because an
economy’s workers are its chief resource, keeping workers employed is a paramount concern of
economic policymakers. The unemployment rate is the statistic that measures the percentage of
those people wanting to work who do not have jobs.

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An individual in the economy can be represented in any of the three ways: employed, unemployed,
or not in the labor force. A person is employed if he or she spent some of the previous week
working at a paid job.
A person is unemployed if he or she is not employed and has been looking for a job or is on
temporary layoff. A person who fits into neither of the first two categories, such as a full-time
student or retiree, is not in the labor force. A person who wants a job but has given up looking—a
discouraged worker—is counted as not being in the labor force.
The labor force is defined as the sum of the employed and unemployed, and the unemployment
rate is defined as the percentage of the labor force that is unemployed. That is,
Labor Force =Number of Employed + Number of Unemployed,
Unemployment Rate =Number of unemployed .100
Labor force
A related statistic is the labor-force participation rate, the percentage of the adult population that is
in the labor force:
Labor-Force Participation Rate = Labor force .100
Population
There three types of unemployment: The cyclical unemployment, frictional and the structural
unemployment.

i. The cyclical unemployment:

It is the unemployment caused by the upswings and downswings of business cycles in the economy.
During an upswing (expansionary phase of a business cycle) unemployment goes down, while
during a downswing (contractionary phase of a business cycle) unemployment goes up. This kind of
unemployment, which fluctuates with business cycles, is called cyclical unemployment. The
downswings of business cycles are caused by decreasing aggregate demand i.e., falling demand for
all goods and services. This in turn leads to an increase in cyclical unemployment. This kind of
unemployment may pervade the whole economy or could be sector specific.
Example: With high gasoline prices, the demand for large cars might fall dramatically. As a result,
this might lead to a huge reduction in production of these vehicles, and again contraction in this
industry caused lots of cyclical unemployment.
ii. Frictional Unemployment:
It is unemployment between jobs. It is also unemployment in the interim period between my
graduating from school and finding the best fitting job for me. I am frictionally unemployed during
this job search period. It is unemployment caused by labor mobility. People move from place to
place, or from job to job. In between these movements, they generally have some period to make
the move, or may take time off with family before settling in the new environment. Here they are
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 frictionally unemployed, in those interim periods. A person making a career move, a homemaker re-
entering the market after the initial child bearing / rearing period, or divorce are frictionally
unemployed. A retiree deciding to get back to work (either to keep busy or for financial needs, as
the case may be). All of them will go through a job search period, trying to find the best fit job.
During that period they will fall in the category of frictional unemployment. Frictional
unemployment is compatible with the definition of full employment, meaning it co-exists with full
employment. It is always there because it does take time for both employer and employee to find
the best match in terms of skills, temperamental compatibility, location, pay etc. When the economy
is growing, in the upswing or expansionary phase of the business cycle, the economy is creating
jobs and hence frictional unemployment goes down. The reverse happens when the economy is
contracting, frictional unemployment goes up.
iii. Structural Unemployment:
It is unemployment due to lack of skills demanded by the market place. Today if I do not know
how to use computers, I will be structurally unemployed. It is unemployment due to the workforce
not having up-to-date skills or skills demanded by the marketplace. It is the worst kind of
unemployment in the sense that it is the most difficult one to get rid of. Acquiring new skills are
easier said than done. This kind of unemployment is mostly seen when the economy is surging in
terms of rapid technological changes. It takes time to train and learn the new skills, and gets to be
even more difficult, especially for the senior people.
2.8.2. Inflation

The inflation between two points in time is defined as the percentage increase of the price index
between these two points in time.
Comment:
 Price index is calculated at a particular point in time, inflation over a time period, typically one
year.
 Inflation may just as well be defined as the percentage change in the price level.
 Inflation is independent of which year we use as our base year for our price index.
 You often hear that inflation is the percentage change in prices but keep in mind that prices is
then short for the price level.
 Since the price level may be defined in many different ways (using different goods and different
weights in the basket), inflation may be defined in many different ways.
 If the price index decreases between two points in time we say that the inflation is negative or
that we have deflation.

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The rate of inflation is the percentage change of a price index Pt, i.e.
(Pt − Pt−1 )100
Pt−1 Where Pt , e.g., may denote the consumer price index.

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

Inflation
Rate Phillips curve

0 Unemployment rate

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