02 National Accounting

Lecture from: 23.09.2025 | Video: Video ETHZ

The Economist’s Toolkit: Models and Assumptions

The previous lecture established the economist’s role as a scientist. A key part of this role is the use of models. To understand a complex world, simplification is necessary. This is the role of assumptions.

Economists make assumptions to distill complex realities into manageable models. The world is too noisy to analyze in its entirety; less relevant factors must be filtered out to focus on the core mechanisms. The art of scientific thinking lies in choosing the right assumptions, those that simplify without distorting the essential question at hand.

Models are Maps

An economic model can be thought of as a map. A map is, by definition, an incorrect simplification of reality. But its usefulness depends on the question being asked. Navigating Zurich requires different maps for understanding municipalities versus city streets.

For navigating London’s subway, the schematic Tube map is far superior to a geographically accurate street map. It intentionally distorts distance and location to make the system understandable. It is “wrong,” but it is useful. Economic models work the same way: simplifying assumptions (e.g., “the world has only two countries”) are made knowingly if they help answer a specific question clearly.

Endogenous vs. Exogenous Variables

In any model, two types of variables are distinguished:

• Endogenous Variables: The outcomes to be explained. Their values are determined within the model.
• Exogenous Variables: The inputs taken as given. Their values are determined outside the model.

This creates a clear cause-and-effect structure: exogenous variables drive the endogenous outcomes. To isolate these effects, the ceteris paribus assumption is often employed, “all other things being equal”, changing only one exogenous variable at a time to observe its impact.

Endogenous vs. Exogenous in Practice

Question: What happens to ice cream sales when the weather gets warmer?

• Exogenous (input): Temperature, taken as given by the model
• Endogenous (output): Ice cream sales, determined by the model

The model might predict: “A 10°C increase in temperature raises ice cream sales by 50%.” Temperature is the cause; sales are the effect.

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Our First Model: The Circular-Flow Diagram

This is a visual model of the macroeconomy showing how money and resources flow between its key actors: households and firms.

In its simplest form, there are two actors and two markets:

1. Households: Own the factors of production (labor, land, capital) and consume goods and services.
2. Firms: Use factors of production to produce goods and services.
3. Market for Goods and Services: Where firms sell and households buy.
4. Market for Factors of Production: Where households sell (e.g., their labor) and firms buy.

The Two Loops

The diagram creates two loops:

• Inner loop (real): Labor flows from households to firms; goods flow from firms to households.
• Outer loop (monetary): Firms pay wages to households; households spend on goods.

Key insight: Total income must equal total expenditure. Measuring the flow of economic activity at any point yields the same answer, like measuring blood flow anywhere in the circulatory system.

The model can be made more realistic by adding other key actors:

• Government: Collects taxes and makes government purchases.
• Financial System: Channels savings from households into investment for firms.
• Rest of the World: Engages in trade (exports and imports) and international capital flows.

Even in this complex model, the fundamental identity holds. This gives three ways to measure total economic activity, or Gross Domestic Product (GDP).

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Our Second Model: The Production Possibilities Frontier (PPF)

The PPF is a graph showing the maximum combinations of two goods an economy can produce given its available technology and factors of production. It is a powerful tool for visualizing core economic concepts.

What the PPF Illustrates

Point	Location	Meaning
A, B	On the frontier	Efficient, resources fully utilized
D	Inside the frontier	Inefficient (e.g., due to unemployment)
C	Outside the frontier	Currently unattainable

Key Concepts from the PPF

1. Trade-offs & Opportunity Cost: Moving from A to B requires giving up 200 computers to gain 100 cars. The opportunity cost of those 100 cars is 200 computers.

2. Bowed-Out Shape: Reflects increasing opportunity cost. Resources are not equally suited for producing both goods. The first car costs few computers; the last car costs many.

3. Economic Growth: A technological advance (an exogenous shock) shifts the frontier outward, making previously unattainable points possible.

Why the PPF Bows Outward

Imagine shifting from all-computers to all-cars. The first workers reassigned are those poorly suited to making computers anyway, they might produce many cars and cost few computers. But the last workers reassigned are computer specialists, reassigning them costs many computers but produces few additional cars. Hence, opportunity cost increases as more of one good is produced.

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The Economist as Policy Advisor

Economists play a dual role. When explaining the world, they are scientists. When trying to improve it, they are policy advisors. This distinction is captured by the difference between positive and normative analysis.

• Positive Statements: Descriptive claims about how the world is. They are testable with data.

  • Example: “An increase in the minimum wage will cause a decrease in employment among the least-skilled.”

• Normative Statements: Prescriptive claims about how the world ought to be. They involve value judgments and cannot be tested.

  • Example: “The income gains from a higher minimum wage are worth more than any slight reductions in employment.”

This course focuses on positive analysis, understanding the mechanisms of the economy.

Why Do Economists Disagree?

Disagreements arise from two sources:

1. Differences in Scientific Judgments: Economists might use different models (maps) or have different positive theories about how the world works.
2. Differences in Values: They may have different normative views about what policy should accomplish.

A KOF-NZZ survey of Swiss economists shows broad consensus on many positive issues (e.g., 92.6% agree that property rights and free competition are central to well-being). Disagreement is much stronger on normative questions, like whether income should be distributed more evenly (39.6% agree, 34.5% disagree).

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Measuring a Nation’s Income: National Accounting

To analyze the economy, it must first be measured. Macroeconomics is the study of the economy as a whole, aiming to explain economy-wide phenomena:

• Why average income differs across countries
• Why prices sometimes rise rapidly (inflation)
• Why economies experience booms and busts (business cycles)

The most important statistic in macroeconomics is Gross Domestic Product (GDP).

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The Measurement of Gross Domestic Product (GDP)

GDP measures two things at once:

1. The total income of everyone in the economy
2. The total expenditure on the economy’s output of goods and services

For an economy as a whole, income must equal expenditure, because every transaction has a buyer and a seller. Every dollar of spending by a buyer is a dollar of income for a seller.

Definition

GDP is the total market value of all final goods and services produced within a country in a given period of time.

Deconstructing the Definition

Component	Meaning
”…Market Value…”	Different items (apples, cars, haircuts) are aggregated using market prices. This values output at what people are willing to pay.
”…of All…”	GDP aims to be comprehensive, including all items produced and sold legally in markets. Excludes most non-market activities (mowing your own lawn isn’t counted; hiring a gardener is). Often excludes the black market.
”…Final…”	Only the value of final goods is included, not intermediate goods. This avoids double-counting. The value of tires is already included in the final price of a car, only the car is counted, not the tires AND the car.
”…Goods and Services…”	Includes both tangible goods (food, clothes) and intangible services (haircuts, financial advice).
“…Produced…”	Measures current production. The sale of a used car is not included, the car was not produced in the current period; it is a transfer of an existing asset.
”…Within a Country…”	Measures production within a country’s geographic confines, regardless of the nationality of the producer.
”…in a Given Period of Time.”	GDP is a flow variable, measured over an interval of time (typically a quarter or a year).

Why Income Equals Expenditure

Consider a simple transaction: someone buys a coffee for CHF 5.

• Expenditure: The buyer spends CHF 5.
• Income: The seller receives CHF 5.

Every transaction is both an expenditure (for the buyer) and income (for the seller). When all transactions in the economy are summed, total expenditure equals total income by definition. This is why the circular flow diagram has two equivalent loops.

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Continue here: 03 Production and Growth