03 Production and Growth

Lecture from: 30.09.2025 | Video: Video ETHZ

Exam Update

Based on technical difficulties experienced during the test run, the final exam format has been changed to a traditional on-paper exam. The bring-your-own-device format has been suspended for this semester.

The schedule is slightly behind due to previous exercises. Today’s lecture will first conclude the material on National Accounting (Lecture 2) before beginning the main topic, Production and Growth (Lecture 3).

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Finishing Lecture 2: National Accounting

The previous session defined Gross Domestic Product (GDP). This section dissects that definition and explores how it is applied in practice.

Deconstructing the Definition of GDP

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

Component	Explanation
”…Market Value…”	Diverse outputs like apples and haircuts are aggregated using market prices. This provides a common unit of account and reflects the value society places on them.
”…of All…”	GDP aims to be comprehensive, including all items produced and legally sold in markets. However, non-market activities are traditionally excluded.
”…Final…”	To avoid double-counting, only final goods are recorded, not intermediate goods. The value of wheat is included in the final price of bread; bread alone is counted.
”…Goods and Services…”	Includes tangible goods (cars, food) and intangible services (haircuts, doctor visits). In modern economies like Switzerland, services constitute the vast majority of output.
”…Produced…”	Measures current production. Items produced this year but put into inventory are counted as “inventory investment.” When sold next year, they won’t be counted again.
”…Within a Country…”	A geographic measure. All production within a country’s borders is included, regardless of the producer’s nationality.
”…in a Given Period…”	GDP is a flow variable, measured over an interval (quarter or year).

What About Used Goods?

The sale of a used car is not included in GDP. The car was counted in the GDP of the year it was produced. The transaction is merely a transfer of an existing asset. However, the service provided by the used-car dealer (their commission) is part of current GDP, as it is a service produced in the current period.

The Shadow Economy

Statistical offices now make efforts to estimate and include illegal activities and unreported work, as these constitute real production. This “shadow economy” can be significant in some countries.

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Three Approaches to Measuring GDP

The circular flow diagram shows that total economic activity can be measured at different points. In practice, statistical offices use three approaches, which should theoretically yield the same result.

Approach	Method	Perspective
Expenditure	Sum all spending on final goods	Demand side
Production	Sum value added at each stage	Supply side
Income	Sum all income earned (wages, rent, interest, profit)	Factor payments

Expenditure Approach:

$$GDP=C+I+G+NX$$

Value Added Approach: At each production stage, value added equals output minus intermediate inputs. Summing across all stages gives GDP without double-counting.

Data Revisions

These three methods use different data sources (retail sales, factory outputs, tax records). They never perfectly align in real-time. Statistical offices first release a quick estimate (often using the production approach) and then revise it over months and years as more complete data becomes available. This is why GDP figures for past years change. For example, Swiss GDP for 2024 was recently revised upwards by nearly 30 billion CHF!

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GDP in Practice: The Swiss Economy

The Production (Supply) Side

Examining value added by sector reveals the structure of an economy. Switzerland has transformed from an industrial economy to a service-based one.

In 1990, manufacturing, construction, and trade/transport made up the bulk of the economy. By 2024, “pure” services (financial, business-oriented, consumer-oriented) account for over half of value added.

The Expenditure (Demand) Side

The standard national income identity is:

$$Y=C+I+G+NX$$

Component	Description
Consumption (C)	Spending by households on goods and services
Investment (I)	Spending on capital equipment, inventories, and structures (including new housing)
Government Purchases (G)	Spending on goods and services by all levels of government. Excludes transfer payments like social security, which are not exchanges for currently produced goods or services.
Net Exports (NX)	Exports (X) minus Imports (M)

Switzerland's Trade Openness

For Switzerland, private consumption is about 51% of GDP. However, this understates the importance of global trade. If Total Demand ($C+I+G+X$, before subtracting imports) is examined, exports account for a massive 45% of total sales. This highlights Switzerland’s extreme openness and dependence on the global economy.

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Real vs. Nominal GDP: Correcting for Inflation

If total spending rises, it could be because the economy is producing more, or because prices have risen. These two effects must be separated.

• Nominal GDP: Values production at current prices.
• Real GDP: Values production at constant prices from a chosen base year.

Why Real GDP Matters

Real GDP is the superior measure of economic well-being because it reflects changes in the quantity of goods and services, stripping out price changes. If nominal GDP doubled but prices also doubled, no one is actually better off, real GDP would be unchanged.

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Measuring the Cost of Living: Inflation

The inflation rate ($\pi$) is the percentage change in the overall price level from one period to the next.

$${\pi }_t=\frac{P_t-P_{t-1}}{P_{t-1}}\times 100$$

Term	Definition
Inflation	Price level rising ($\pi >0$)
Deflation	Price level falling ($\pi <0$)

But what is the price level, $P$? Two main measures exist.

The GDP Deflator

The GDP deflator measures the price level using GDP data. It shows how much of the rise in nominal GDP is attributable to price increases.

$$\text{GDP Deflator}=\frac{\text{Nominal GDP}}{\text{Real GDP}}\times 100$$

The Consumer Price Index (CPI)

The CPI is the most common measure of inflation. It tracks the overall cost of a fixed basket of goods and services bought by a typical consumer.

How the CPI is Calculated:

1. Fix the Basket: Survey data determines the “shopping basket” of a typical consumer.
2. Find the Prices: Prices of all basket items are collected over time.
3. Compute the Basket’s Cost: The total cost is calculated for each time period.
4. Choose a Base Year and Compute the Index: $\text{CPI}=\frac{\text{Cost of basket in current year}}{\text{Cost of basket in base year}}\times 100$
5. Compute the Inflation Rate: The percentage change in the CPI from the preceding period.

Problems in Measuring the Cost of Living

The CPI systematically overstates the true cost of living due to three key biases:

Bias	Problem
Substitution Bias	The CPI uses a fixed basket. When one good’s price rises, consumers substitute towards cheaper alternatives. The CPI misses this substitution.
Introduction of New Goods	New products increase variety and make each dollar more valuable. The fixed basket doesn’t account for this until updated years later.
Unmeasured Quality Changes	If a computer’s quality improves but its price stays the same, purchasing power has increased. The CPI struggles to fully account for such improvements.

GDP Deflator vs. CPI

These two measures track each other closely but can diverge:

Difference	GDP Deflator	CPI
Scope	All goods/services produced domestically	All goods/services bought by consumers (including imports)
Basket	Uses currently produced basket (updates automatically)	Uses fixed basket

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Correcting Economic Variables for Inflation

Price indexes are used to compare monetary figures from different times. This is called indexation.

$$\text{Value in today’s dollars}=\text{Value in past dollars}\times \frac{\text{Price level today}}{\text{Price level in past}}$$

The same logic applies to interest rates:

• Nominal Interest Rate: As usually reported, without inflation correction.
• Real Interest Rate: Corrected for inflation effects.

$$\text{Real interest rate}\approx \text{Nominal interest rate}-\text{Inflation rate}$$

The Real Interest Rate

The real interest rate measures the true return to saving and the true cost of borrowing. If the nominal rate is 5% but inflation is 3%, the real rate is only 2%, that’s the actual increase in purchasing power.

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The Centrality of Production and Growth

The focus now shifts to the long run. A country’s standard of living is fundamentally determined by its ability to produce goods and services. The differences are staggering.

The key to understanding these differences lies in economic growth. Even seemingly small differences in annual growth rates have enormous effects when compounded over many years.

• In Switzerland, real GDP per capita has grown by about 0.8% per year since 2000. This seemingly modest rate implies that GDP per capita doubles roughly every 87 years.
• If Switzerland’s growth had been just one-tenth of one percent higher (0.9% instead of 0.8%) since 2000, the average individual would have earned an additional CHF 24,590 over that period.

The Magic of Compounding

The Rule of 70: To estimate how many years it takes for something to double, divide 70 by the growth rate (in %).

• 1% growth → doubles in ~70 years
• 2% growth → doubles in ~35 years
• 7% growth → doubles in ~10 years

Small policy changes that nudge the long-run growth rate can have a monumental impact on future generations.

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Productivity: The Engine of Growth

The ultimate driver of a country’s standard of living is productivity.

Productivity: The quantity of goods and services produced per unit of labor input (e.g., per hour of a worker’s time).

To enjoy a high standard of living, a nation must produce a large quantity of goods and services. To understand why incomes are so much higher in Switzerland than in the Central African Republic, the focus must be on why the average Swiss worker is so much more productive.

The Determinants of Productivity: The Factors of Production

Productivity is determined by the inputs used in the production process, known as the factors of production. They can be categorized into four key types:

Factor	Symbol	Description
Physical Capital	$K$	The stock of equipment and structures used to produce goods. Capital is a produced factor, it is output of past production that serves as input for current production.
Human Capital	$H$	The knowledge and skills workers acquire through education, training, and experience. Like physical capital, it is a produced factor.
Natural Resources	$N$	Inputs provided by nature (land, rivers, minerals). Can be renewable (forests) or non-renewable (oil). Important but not prerequisite, see Japan, Switzerland.
Technological Knowledge	$A$	Society’s understanding of the best ways to produce. Refers to the quality of society’s “textbooks,” while human capital is how much time people have spent reading them.

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Continue here: 04 Unemployment and the Labour Market