CHAPTER TWO
NATIONAL INCOME ACCOUNTING
The concept of GDP and GNP
•To understand the meaning of GDP and GNP more fully, we turn to national
income accounting.
• National Income Accounting (NIA): the accounting system used to measure
GDP and many related aggregate economic activities.
• It is official measurement of flow of income and production in a given
economy.
•Gross domestic product (GDP) is the market value of all the final goods and
services produced within the domestic territory of a country during a year.
• In Gross Domestic Product, we include only the goods and services produced
within the domestic territory of a country. It includes the incomes locally
earned by the non-nationals and excludes the incomes received by the resident
nationals from abroad.

 Gross National Product (GNP) is the total market value of all final
goods and services produced by residents/ citizens of nations.
 We may say it is the Gross Domestic Product at market price plus NFI
(net factor income from abroad minus factor income of non-residents
in domestic tertiary).
 Thus, GNP = GDP + NFI Where, GNP = Gross National Product at
market prices GDP = Gross Domestic Product at market prices NFI =
Net Factor Income
 NFI is the difference between factor income flowing out of the
country and flowing into the country.
 Alternatively, it is the difference between the factor income by a
country’s citizen living abroad and the factor income earned by
nonresidents (foreigners) in the domestic territory of that country.
 NFI = Factor income earned from abroad by residents – factor income
of non-residents in domestic territory
 Net factor income from abroad can be positive or negative.
 When net factor income from abroad is positive, domestic product is
smaller than the national product (or the national product is greater
than the domestic product).
 And when net factor income from abroad is negative, domestic
product is greater than the national product.

Approaches to Measuring GDP/GNP
 There are three different phases in circular flow of
national income: production, income and expenditure.
 Production of goods and services is the result of
combined efforts of factors of production (land, labour,
capital and entrepreneurs).
 The net output emerging from the production process
gets distributed in the form of money income (rent,
wages, interest and profit) among factors of production.
 With these income factors of production we purchase
goods and services for final consumption and
investment.
 In this way income creates expenditure. Expenditure in
turn gives rise to further production.
 This leads to continuous circular movement of
production, income and expenditure.

Income Method
 The income method measures national income from the side of payments
made to the primary factors of production in the form of rent, wages,
interest, and profit for their productive services in an accounting year.
 Since the income of factors of production is cost to their employers, so
factor income and factor cost are the same.
 Thus if the factor incomes of all the producing units generated within the
domestic economy are added up, the resulting total will be the domestic
income at factor cost.
 If we add the value of depreciation and indirect taxes to this, we get GDP.
Adding further net factor income from abroad gives us GNP.
 Depreciation means loss of the value of fixed capital assets during
production.
 In other words, depreciation is the value of existing capital stock that has
been consumed (used up) in the process of producing output.
 Fall in the value of fixed assets due to normal wear and tear and to
expected obsolescence is called consumption of fixed capital or
depreciation.

 Indirect Business Taxes are taxes levied by the
government on production and sale of commodities.
 For example, excise duty, sales tax, custom duty, etc. The
buyer of a taxed commodity pays the tax indirectly
because the tax is included in the price which the buyer
pays. The effect of indirect tax is that it increases the price
of a commodity.
 The following steps are involved in estimating national
income by the income method.
• Identifying enterprises which employ factors of production
(land, labour, capital and entrepreneurships),
• Classifying various types of factor payments like rent,
wages, interest and profit,
• Estimating the amount of factor payments made by each
enterprise,
• Summing up of all factor payments made within the
domestic territory to get the domestic income at factor
cost,

 Adding the value of depreciation and indirect taxes to
domestic income at factor cost to get GDP MP ,
 Estimating net factor income from abroad, which is
added to GDP to obtain GNP. To correctly compute
national income by the income method, the following
precautions need to be taken.
 Only factor incomes which are earned by rendering
productive services are included. All types of transfer
income are not included.
 Imputed rent of owner-occupied dwellings and the
value of production for self-consumption are included,
but the value of self-consumed services is not
included.
 Income from illegal activities like smuggling, black
marketing, etc., as well as windfall gains from
lotteries, etc., is not included.

 Example: GDP at market price measured by
income approach, of a hypothetical nation.
 Types of Income Amount (in millions Birrs)
 Compensation of employees84,000
 Rental income 9,200
 Interest income 12,100
 Profits (proprietor’s income) 30,000
 Depreciation 10,000
 Indirect business taxes 4,000

Expenditure Method
 The expenditure method gives us the value of GDP
when measured at the point of expenditure. From
the expenditure point of view, GDP is gross
expenditure on the final use of domestically
produced goods and services during a period of
account.
 Basically the final use of goods and services is for
two purposes: consumption purposes for direct
satisfaction of wants, and investment purposes, for
expanding productive capacity.
 And expenditure on them is called final
consumption expenditure and final investment

 There are 4 main components of expenditure that
adding up and give GDP.
 Consumption expenditure( C):It measures the money
value of goods and services purchased by
households for current use during a time period. In
this category we include consumption expenditure
by consumer households on all types of consumer
goods (i.e., durable, semi-durable, and nondurable
goods and services).
 Investmentexpenditure (I ) Gross fixed capital
formation: Expenditure on it consists of mainly two
items Construction, and Machinery and equipment.

 Change in stocks: This refers to the physical change in
stocks of inventories like raw material, semi-finished goods
and finished goods lying with the producers for smooth
working of production processes. It is the difference
between the stocks in the beginning of and at the end of
the accounting year.
 Government final consumption expenditure: It is defined
as “Current expenditure on goods and services incurred in
providing services of government administrative
departments less sales.” It is incurred by general
government to satisfy collective needs of the people. For
example, government expenditure on health, education,
general administration, law and order, etc. belongs to this
category.
 Net exports (exports less imports): This refers to the
difference between the value of exports and value of
imports. Note that exports and imports include both
material goods as well as services.

 We may thus sum up as follows:
GDP=C + Ig + G + (X – M) where C is consumption
expenditure, I is Investment expenditure G is
Government expenditure and NX is Net export
 Example: Calculating GDP by expenditure approach
 ExpenditureAmount (in millions of Birr)
 1. Personal final consumption expenditure 12,000
 Durable goods 4,500
 Non durable goods 1,500
 Services6,000
 2. Government final consumption expenditure 5440
 Federal defense1040

3 Gross fixed capital formation (Gross private Domestic
Investment)7410
 Construction Expenditure3,940
 Machinery equipment Expenditure2,200
(Business fixed investment)
Changes in inventories1,270
4. Net Exports -11
 Exports 194
Imports 205
 GDP: 24,839
 •To avoid double counting, expenditure on all
intermediate goods and services is excluded.
 • Government expenditure on all transfer payments,
such as scholarships, unemployment allowances, old
age pensions, etc., is excluded because non-productive
services are rendered by the recipients in

Production Method (Value Added Method)
 In this method two approaches – ‘Final Product
Approach’ and ‘Value AddedApproach’ – are adopted.
 i. Final Product Approach: According to this approach,
in the estimation of
 GDP, we include the market value of all final goods and
services produced in a country. For example, if we
manufacture thread from cotton, cloth from thread and
shirts from cloth, here shirts are the final good. Hence,
we should include the value of shirts only in the
calculation of national income.
 Thus, GDP is calculated by multiplying all the final
goods and services produced in a country with their
respective market prices.
 GDP = P (Q) + P (S) Where, P = Market price
 Q = Quantity of goods
 S = Quantity of services

 Problem of Double Counting in the Final Product
Approach: The final product approach cannot be
used in actual practice because production is a
continuous process and in this process it is difficult
to know the final product. It gives rise to the
problem of double counting.
 What is the problem of double counting? Counting
the value of a commodity more than once in the
measurement of national income is called double
counting.
 So far as an individual enterprise is concerned, it
considers its output as final product.

 For example, for a farmer, cotton is a final product, for
a spinning mill, thread is a final product, for a cloth-
mill, cloth is a final product, and for a garment
manufacturer, shirts are a final product.
 All these enterprises take the sale value of their
products as the value of their final output.
 Since the above three methods are only different
viewpoints of the same flow of goods and services,
totals from each method should therefore be equal to
each other.
 When we take into account the sum total of the value
of output of all these individual enterprises in the
estimation of national income, it suffers the problem of
double counting.
 This leads to overestimation of the value of goods and
services produced.
 To overcome the difficulty of double counting, the
value added approach is used.

 ii.Value Added Approach: The value added
approach measures the value added (contribution)
by each producing enterprise in the production
process in the domestic territory of a country in an
accounting year.
 Value added is defined as the difference between
total value of the output of a firm and the value of
inputs bought from other firms.
 Clearly, the value added approach measures the
contribution of each producing unit in the
domestic economy without any possibility of
double counting.

 The following steps are involved in estimating
national income by the value added approach:
 Identifying all the producing units in the
domestic economy and classifying them into
three economic sectors: primary, secondary and
territory sectors.
 (The primary sector exploits natural resources,
the secondary sector transforms one type of
commodity into another, and the tertiary sector
renders services.),
 Estimating the value added by each producing
unit. (By deducting intermediate consumption,
from value of output, we get the value added.),

• Estimating the value added of each economic
sector by summing up the value added of all
producing units falling in each industrial sector,
• Computing GDP by adding up the value added of
all economic sectors.
• Estimating net factor income from abroad which
is added to GDP to obtain GNP.
 Example:
Suppose there are four different stages having
their own market transactions in production of
bread.

Stages values of transaction value added
 Farmers grow wheat and sell to miller owner
0.12 0.12
 Miller convert wheat to flour and sell to baker
0.28 0.16
 The baker bake bread and sell to store owner
0.60 0.32
 Store owner sell bread to consumer 0.75
0.15
 0.75 = GDP


OtherSocial Accounts (GNP, NNP, NI, PI and DI)
 GNP - Gross National Product It is the total market
value of all final goods and services produced by
residents/ citizens of nations.
 NNP- Net National Product: It is the net market
value of all the final goods and services produced by
the normal residents of a country during a year. It can
be calculated as:
 NNP = GNP– Depreciation where Depreciation
means loss of the value of fixed capital assets during
production.
 NI- National income (product) at factor cost expresses
national income as the sum of all factor payments. It
is income generated by factors owners.
 It includes the following components.

 i.. Employment compensation income – wage
and salaries
ii. Proprietor income – income earned by owner
and un corporate business
iii. Corporate income (profit) – income earned
from corporate business. It includes corporate
tax, dividends and retained earning
iv. Rental income- income earned from capital
assets like machineries
v. Net interest – money income paid to savers
and loanable funds.

 Personal Income (Y)Personal income is the sum
of earned income and transfer income received
by persons (households) from all sources within
and outside the country.
 The point to be noted here is that personal
income includes not only factor incomes which
are earned from productive services but also
transfer incomes (or payments) which are
received without rendering any productive
service.
 It is a receipt concept as compared to national
income, which is an earning concept.

 Note that national income is not the sum total of
personal incomes, since the former includes only
earned incomes, whereas the latter includes earned
incomes as well as transfer incomes.
 Again, personal income is different from national
income because two components of national income,
namely, corporate tax and undistributed profit of
corporate enterprise are not included in personal
income.
 The reason is that corporate tax goes to the
government and undistributed profit is retained by the
company — i.e., these two are not received by
households.
 Personal Disposable Income (Yd ): Personal disposable
income is that part of personal income which is
available to the households for disposal as they like .

 Alternatively it is the income which remains with
individuals after deduction of taxes and fees of the
government.We can say, it is the income which the
households can spend on consumption or can save
as they please.
 Because households utilize personal disposable
income for personal expenditure and personal
savings, PDI is also equal to personal expenditure +
personal savings. Personal disposable income can
be arrived at by deducting personal taxes (like
income tax, property tax, fire tax, etc.) from
personal income.Thus, Personal Disposable
Income (Yd ) = personal income (Y) – personal
taxes

 Nominal GDPversus Real GDP
 Economists use the rules just described to compute GDP,
which values the economy’s total output of goods and
services.
 Economists call the value of goods and services measured
at current prices nominal GDP. Notice that nominal 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,
nominal 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.

 A better measure of economic well-being would tally
the economy’s output of goods and services without
being 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 2009 with output in subsequent
years for economy.
 We could begin by choosing a set of prices, called
base-year prices, such as the prices that prevailed in
2009. Goods and services are then added up using
these base-year prices to value the different goods in
each year.

 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.
 Significance of the Distinction
 1 Real GDP (i.e., at constant prices) truly reflects the
performance and level of economic growth in an economy,
whereas Nominal GDP (i.e., at current prices) does not.
Nominal GDP is affected by two factors: Change in physical
output, and Change in prices.
 If current market prices rise fast, Nominal GDP will also rise
fast even though physical output remains the same.
 In contrast, real GDP is affected by only one factor, change in
physical output because prices are fixed or constant. Thus
real GDP can rise only when there is a rise in physical output
during a year.

 A country is interested in change in physical
output (real GNP) and not in monetary or
Nominal GDP because an increase in real GDP
leads to a rise in the standard of living of the
people.
 2 Real GDP is a better tool for making a year-to-
year comparison of changes in the physical
output of goods and services. A sustained rise in
real GNP reflects the economic growth of the
country, whereas a continuous fall in real GDP is
an indicator of recession, and depression.
 3 Real GDP is often used in making international
comparisons of economic performance across
countries.

GDP Deflator versus CPI
• measures price of output of current year
relative to base year price
• GDP Deflator =
where Pc is general current year price, Pb is general base
year price
Consumer price index (CPI) measures the price of fixed
“market basket” of consumer goods and services
purchased by consumers relative to the price of that bundle
during a particular base year. The base year is a reference
year.

• CPI =
where Pc is general current year price, Pb is general base
year price
CPI tells us that how much it costs now to buy products
relative to the same products in base year.

Difference between GDP Deflator and CPI
 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 GDP deflator allows the basket of goods to change
over time as the composition of GDP changes.

Unemployment and Inflation
Unemployment
 Unemployment is a situation in which able bodied
persons willing to work at prevailing wage rate do
not able to find job.
 It is measured by rate of unemployment, which
represents the percentage of those people who
wants to work but cannot get any job.
 Unemployment rate = ( )100
No of unemployed
labor force
where labour force is all persons over age 16 who
are either working for paid job or actively seeking
paid employment
( )100
No of unemployed
labor force

Types of unemployment
 Frictional unemployment.
Unemployment at full employment is termed as
frictional unemployment.
 The reason behind frictional unemployment is
that it takes time to match workers with jobs.
 The flow of information about job candidates
and job vacancies is imperfect.
 Geographical mobilties of workers are not
instantaneous, in addition workers difference in
preference and jobs have different attributes.
 For all these reasons, searching for an

 Structural unemployment
 Structural unemployment arises due to structural change in
dynamic economy and wage rigidity.
 Such structural change includes change in the structure or
sectorial composition of the economy due to technological
change.
 That is gradual decline of some kind of industries production and
the emergence of new industries.
 This situation makes some peoples with certain specific skill out
of the labor demand resulting in structural unemployment.
 Technological change also alters the demand pattern of different
kind of skills.
 Some skills become obsolete and less efficient resulting
mismatch between labor demand and supply.
 The second reason for structural unemployment is wage rigidity.
Workers are unemployed sometimes not because of the skill gap
at on-going wage rate but, the supply of labor exceeds the
demand. The wage rate did not adjust to full employment level
due to different factors.

Some of them are presented as follows.
 Minimum wage law
 Minimum wage law is a law which set a legal
minimum wages that firms pay their employee with
different skills.
 This will cause wage rigidity not to adjust to
equilibrium level and creating unemployment.
 Unions and collective bargaining
 The wages of unionized workers are determined
not by the equilibrium of supply and demand.
 It is determined by collective bargaining between
labor union leader and management.
 In most cases they agree on wage above
equilibrium level associated with a certain level of
unemployment

 Efficiency wage argument
 According to efficiency wage theory higher wages make
workers more productive.
 So if wage increase the productivity of workers, firms
will not cut the wage of workers even though there is
excess labor supply.
 As economists argue high wage increase wage
productivity in different ways:
 Higher wage enable workers to afford nutritious food
and then have better health condition.
 If workers become healthier they can supply more labor
and effectively undertake different activities they are
assigned to.
 It also reduce labor turnover.
 The more firms pay its workers, the greater their
incentive to stay with the firm.
 Therefore firms reduce labor turn over (cost and time of
hiring and training new workers) by paying their

 High wage reduce adverse selection in labor
market. That is higher wage select quality (better
performing) workers among less efficient workers.
 High wage reduces the problem of moral hazard
that exists between workers and firms. This is
because when workers paid high wage above
equilibrium, it improve workers effort with
minimum monitoring.
 All the above factors make wage rate rigid above
the full employment equilibrium point resulting in
structural unemployment.

Cyclic unemployment
 Cyclic unemployment is unemployment created
associated with short run fluctuation of the
economy.
 Workers become unemployed for some period
when their job evaporates due to recession and
returns to job when there is expansion in
economic activities.
 Seasonal Unemployment
 Unemployment occurred due to absence of job
in particular season.
 5. Disguised unemployment – unemployment
occurred when more workers are engaged in job

Inflation
 In a broad sense, inflation is defined as a sustained
rise in the general level of prices. Two points
about this definition need emphasis.
 First, the increase price must be a sustained one,
and it is not simply a once for all increase in prices.
 Second, it must be the general level of prices,
which is rising; increase in individual prices, which
can be offset by falling in prices of other goods is
not considered as an inflation.

 Thus we define inflation rate (Πt) as:
 Πt= Pt- pt-1 x100
 Pt-1
 Where Ptis overall price index (CPI, GDP
deflator) for time –t
Pt-1 is over all price index for time t-1
 Cause of inflation
 Theories that deal with the causes of inflation
generally classified into two major groups:
Demand pull and cost push factors

 (i)Demand pulls factors.
 According to demand pull theory of inflation, inflation is
the resulted from a rapid increase in demand for goods
and services than supply of goods and services (fixed level
of goods and services supplied).
 Classical and Keynesian school explain differently the
reason for increase in demand for goods more rapidly
than supply.
 For classical economist it is the result of monetary
expansion.
 Increase in money supply (additional flow of money in
the economy) will increase demand for new investment
and rises aggregate demand for goods and services.
 This can be indicated by upward shift in aggregate
demand curve from AD0 to AD1 indicated in the following
figure.

Y 1
Y
P0
p1
Output/income
Figure: 2 demand pulls inflation
AD1
AD0
Price

 This will create excess demand in the economy
equals to . At equilibrium price, P0
consumers, businesses firms and government
would want to purchase Y1 amount, but
producer still supply only, amount.
 This excess demand causes the price to rises to
P1.
 If the supply of goods and services is constrained
by the predetermined full employment level of
output as classical assumed or cannot increase
as fast as demand, the excess demand in goods
market cause raise in general level of price
(inflation)
1
Y Y

Y
1
Y Y

Y

 Classical economists considered an increase in money
supply as a cause of increase in aggregate demand and
then inflation.
 For Keynesian aggregate demand increase also due to
an increase in real factors such as increase in consumer
demand, investment demand, government expenditure
and Net export.
 Such change may take place even when supply of
money is constant. Inflation for Keynesian model is
therefore initiated by fiscal or other non-monetary
disturbances that cause excess demand for goods and
services.
 In general demand pull inflation is inflation initiated by
some events, whether monetary, fiscal or private
spending behaviour that cause increase in the
aggregate demand above aggregate supply at fast rate

 Cost push (supply side) factors
 Cost push inflation occurs when different factors which
increases cost of production (increases price of input)
and other structural bottle neck cause firms to reduce
the supply of goods and services below existing
demand.
 Now let us consider AD-AS model to explain how the
above mentioned condition results in inflationary
conditions.
 As indicated in the following figure. Aggregate supply
curve shifts upward from AS to AS1 for a given level of
price.
 This happens when different factors causes supply of
equilibrium output decrease from Y0 to Y1 which result
in increase in price due to excess demand created at
initial equilibrium level of prices.

• At initial equilibrium price producers supply Y2
amount of output, but consumers, government and
business firms wants to purchase Y0–Y2 amount. This
excess demand for goods and services push price to
increase from P0 to P1.
Price
AS1
Y1 Y0
P0
P1
AS0
AD
Y2 Output/ income
Figure: 2.3 cost push inflation

 As indicated above one factor which cause decline in
supply of goods and services at on-going demand
includes increase in price of input like labour, oil and
other raw material, these factors cause increase in
cost of production, decrease in labour employment
and output supplied.
 The other supply side factors is different types of
supply shocks which result in unexpected disturbance
in supply position of some major commodities or key
industrial inputs.
 When the shocks reduce the supply of some items
that have large weight in price index, there is sudden
rise in the general prices of an economy. Such items
for example includes food prices due to crop failure
and price of industrial input like coal, steel , cement,
oil and basic chemicals.

 The rise in price may be also caused by supply
bottleneck in domestic economy or
international events.
 The Sudden rise in the OPEC oil prices during
1970s due to Arab-Israel war can be cited as
supply shock that causes inflation.
 Most of the inflation theories developed above
are based on institutional setting and
assumptions relevant to developed western
economies.
 The search for appropriate explanation to
inflation in less developed countries led to the
emergence of a new school of economists called
the Structuralist theories of inflation.

 According to the Structuralist view, inflation in
developing economies is caused mainly by the
structural imbalances in these economies. The
major structural imbalance includes:
 Food scarcity: Defective system of land owner
ship, low rate of saving and investment,
technological backwardness and low level of
agricultural infrastructure causes low food supply
against rising demand for food due to increase in
population and urbanization.
 This will create gap between demand and supply
which result in increase in food price.

 Resources imbalance: Most LDCs are surplus in
labour but extremely deficient in capital and
other complementary resources.
 Capital deficiency is caused by low levels of
income, saving and investment.
 In addition, government of LDCs has experience
of gap between its expenditure and revenue.
 To finance deficit or the gap, government
increase money supply without increasing
output.
 This will cause difference between supply and
demand for goods and services which leads to
inflationary condition.

 Foreign exchange bottle necks: LDCS heavily
depend on import for the development needs for
capital goods, industrial raw materials and other
essential goods.
 For this reasons, they need foreign exchange. But
foreign exchange earnings are very low because of
their comparatively low exports.
 Their exports are low due to their low exportable
surplus, high cost of production, inferior product
quality and low competitiveness of their goods in
foreign market.
 This result in severe scarcity of foreign exchange.
Therefore, they are forced to adopt restrictive policy
which results in reduction of domestic supply and
leads to substantial rise in price.

 Infrastructural bottle necks: LDCs are
characterized by inadequate and inefficient
industrial infrastructures which cause the
growth of industrial output low than rising
demand.
 On the other hand, growth imperative force call
for further investment in infrastructural facilities
which fuel expansion of demand, eventually end
up with inflation.

 Economic effect of inflation
 Generally inflation reduces real money balance
or purchasing power of money.
 Banks charge their customer a nominal interest
rate from their loans. Nominal interest rate
however determined based on inflation rate as it
is represented by fisher’s equation below.
 I= r+П ---------Fisher’s equation
 Where I- nominal interest rate, r-real interest
rate
 П -expected inflation.
m
p
 
 
 
m
p
 
 
 

 Therefore, increase in inflation will increase in the
nominal interest rate and cost of money holding.
That is, the opportunity cost of holding money is
the interest income for gone by holding liquid
money rather than buying government bonds or
deposits of bank.
 This implies inflation decreases demand for money
(cash holding) and changes asset portfolio
management.
 If the portfolio holding shifts from money to
consumer durable, inflation causes decline in
economic growth by reducing investment.
 But if the portfolio management shifts to capital

 Inflation reduces investment by increasing
nominal interest rate and creating uncertainty
about macroeconomic policies.
 Inflation increases uncertainties about
macroeconomic policy and adversely affects
the public decision making ability.
 Inflation redistributes wealth among
individuals.
 Unanticipated inflation hurts individuals with
fixed income (pension).

 Shoes leather cost of inflation. Inflationary condition lowers
the purchasing power of money. So if people hold more
money its cost will increase which is measured in terms of
interest rate forgone by holding liquid money. Therefore
people hold lower money balance on average and they must
frequently go to banks to withdraw their money. This will
cause different type of cost and metaphorically it is known
as shoe leather cost of inflation
 High inflation always associated with variability of prices
which includes firms to change their price list more
frequently and requires printing and distributing new
catalogue. This is known as menu cost of inflation.
 Some economist believes that moderate level of inflation (2
to 3) percent per year is good to stimulate the economy.
That is a moderate level of inflation reduces real wage and
then increase level of employment (decreases
unemployment) and output.

 Measures to control inflation
 Monetary measures
 As we discussed before, classical
macroeconomists argue that inflation is any
time a monetary phenomenon.
 That is inflation originate from increase in
money supply in excess of its optimal level.
 Therefore, they hold the view that control of
money supply through appropriate monetary
policy (Bank rate, reserve requirement ratio,
open market operation) greatly effective in
controlling inflation.

 Fiscal measures
 Keynesians or fiscalists argue that inflation originates in
the real (product) sector due to an increase in aggregate
demand in excess of aggregate supply.
 The excess demand may result from the increase in
expenditure by households, firms and government.
 Therefore, fiscal policy or the budgetary measure are a
more powerful and effective weapon to control demand
pull inflation.
 When excess demand is caused by the government
expenditure in excess of real output, the most effective
policy measure is to cut public expenditure.
 On the other hand if the excess demand is caused by the
private expenditure, that is, the expenditure by
households and firms, taxation of incomes is a more
appropriate measure to control inflation since taxation
reduces disposable income.

 Price and wage control measures.
 Monetary and Fiscal policies are
ineffective in controlling cost push
inflation.
 Thus if the inflationary condition is the
result of cost push, it is advisable to
introduce price and wage control
measures rather than using monetary
and fiscal policy.

 Flucuaion in Economic Activities
 Economic fluctuations are
simply fluctuations in the level of the national
income of a country representing growth or
contraction. A market economy is not static. It's
dynamic.
 A rise in national income means an economy is
growing, while a decline in national income
means that an economy is contracting.
 For a whole economy to trend upward or
downward, it is necessary to look at the
aggregate demand side of the economy and
that means looking at what is happening to

The Business cycle
 The ups and downs of the economy in the short
run are known as business cycle.
 It is a regular pattern of expansion and
contraction in economic activity around trend
growth.
 All industrialized societies are subject to recurrent
fluctuations in economic activity.
 Even though the fluctuation characterizes all
macro variables, in most case business cycle
primarily represents fluctuation of output or GDP
along the trend.

 Phases of Business Cycles
 There are four distinct phases of cycles through
which economy can be moving. These phases
have been called by different names by different
economists
1. Depression (Trough) or Lower turning point
phase
2. Recovery (Expansion) or upswing phase
3. Boom (Peak) or Upper turning point phase
4. Recession (contraction) or Downswing Phase
Depression (Trough) is when the level of
economic activity (level of production and
employment) at the lowest level.

 Recovery (expansion) Phase is the phase when
revival of economic activity makes economy to
move to peak. In this phase, both output and
employment are increasing. The gap between
potential output and actual output closes to zero.
Due to high economic activity people enjoy a high
standard of living.
 Full employment of resources and production
implies there is no involuntary unemployment.
 Boom (Peak) phase is when the level of economic
activity (level of production and employment) is at
the highest level.
 Recession (contraction) phase is the phase when

Fig: phases of business cycle without growth trend

 Theories of Business Cycles:
 There are different schools which explain the cause of cyclic
fluctuation of output (economic activity) along the trend. Let
us consider some of them.
 Keynes argued that a deficiency of spending would tend to
depress an economy.
 This deficiency might originate from low consumer saving,
business investment or insufficient government spending.
 Whatever its origins, lack of aggregate demand would cause
persistently high unemployment and then depression.
 If total spending increases, business firms find themselves
profitable to invest and increase output.
 To produce more output, business firms employee resource
which causes expansion of output.
 This fluctuation of output along trend for Keynesian is the
result of fluctuation in aggregate demand.

 Monetarist theory of business cycle
 The monetarists argue that in the long run output is
determined by the supply side of the economy to give a
level of output consistent will full employment.
 In this case changes in the rate of growth of the money
supply only leads to changes in the prices level.
 In the short run, however, changes in the money supply
can cause fluctuations in the level of output .
 Since money and credit affect the ability and willingness
to pay of peoples, change in money supply cause change
in aggregate demand and then output produced.
 That is contraction of money supply causes contraction of
the economic activities by contracting aggregate demand
(total spending of the economy).
 On the other hand expanding money supply causes
expansion of aggregate demand through decreasing
interest rate and increasing price level

Real business cycle theory
 Real business cycle theorists’ emphasizes the real
sector as a determinant factor for business cycle.
 Fluctuation for level of output and employment along
the trend is the result of different real shock hitting the
economy.
 These real shocks include technological changes,
International disturbances, climate changes and other
natural disasters. Assume that there is favourable
shock to technology.
 This will increases labor productivity, labor demand
and current real wage resulting in expansion of the
total output.
 When there are negative technological shocks, the
total output produced in the economy declines in the
short run. Such response of the economic activities to
real shocks causes business cycle.

 Rational expectation theory
 A rational expectation model assumes that agents
expectation about the future value of macro
variables made by the best use of whatever
information is available to them and the
expectations are formed in a manner consistent
with the way the economy actually operate.
 The crucial element in this view is how these
fluctuations in money are transmitted in to output.
In this transmission mechanism individual
producers play a key role, since it is their inability to
distinguish between changes in general level of
price and changes in relative prices when they form
expectation give rise to the business cycle.

 The problem faced by producers is that they are
not able to observe the aggregate price level in
current period, although they assumed to have
expectation as to what it will be. If these
expectations are correct then there is no
business cycle.
 That is if expected and actual prices resulted
from change in money supply (aggregate
demand) are identical then there is no deviation
of output from its trend.
 Therefore it is the deviation of expected price
from the actual price that results in business
cycle according to New classical theory.

 Output grows faster than the trend level; if the
actual price faster than expected average price.
 This is because if suppliers believe they observe
their prices rising faster than inflation; they are
encouraged to raise output above the trend level.
 When they realize that they have made mistakes
and that the rise in their prices was just a rise in the
average price level, output falls back to its trend
rate.
 Thus business cycle, are generated by agents’
misperceptions of their prices relative to the
average price level.