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Liu Yuhui: “A Perspective on the Macro Chess Game” -- The Key to Understanding Global and Chinese Macroeconomic Operations

Summary of this issue

 1. Macroeconomics is complicated, and many books are written. How to find a key to understanding the operation of macroeconomics?

 2. What are the core differences between the real economic world and the Keynesian economic world?
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A key to understanding macroeconomics

  So in the first part, let's first talk about macro ABCs and give you a key, so that everyone can more easily and directly enter my macro world or my macro research in the future. I want to achieve this goal, so I think this part is still necessary. I tried to condense a stack of books to less than 1,000 words to create such a reading experience, and then introduce them to everyone.

  First, let's talk about what macroscopic research questions are. We have seen so many genres, from classical economics to neoclassical, to today's more complex so-called dynamic financial economics framework, what exactly is macroeconomic research. There are so many works, but in fact, the macroscopic research that everyone is focusing on mainly revolves around three issues.

  

Liu Yuhui: “A Perspective on the Macro Chess Game” -- The Key to Understanding Global and Chinese Macroeconomic Operations -1


The first one is what is the long-term source of economic growth

  I think everyone definitely has a certain foundation in this regard; in fact, it's talking about the supply side, such as production function, potential growth, and the long-term growth engine of an economy. The dotted line in the chart below shows the long-term path of balanced economic growth. Corresponsibly, what we are studying in the macroeconomic framework is the supply side. This path is constructed by various production functions and various models. Researchers in this field are actually constructing various models of growth for this path. That's the first question.

The second problem is economic fluctuations and economic cycles

  In fact, I'm talking about demand in the economy; I'm talking about the actual economic growth path shown by the red line in the chart above. What makes this path possible? It is achieved by the purchasing power created by monetary credit. What we see today is a solid line of data on GDP that is regularly published by the Bureau of Statistics. In other words, the so-called troika we are familiar with. Simply put, it is investment, consumption, and net exports, that is, external demand.

  Across the macroeconomic world, we see that the actual growth curve does not match the equilibrium growth curve, which means that aggregate demand and supply and potential growth do not fit perfectly. It can be said that actual growth fluctuates and deviates from time to time around balanced growth. What happened? Economic fluctuations, or economic cycles. As a result, there was inflation and deflation. When the actual growth curve is above the supply side of the equilibrium growth curve, that is, when aggregate demand pulls above potential growth, the gap we see represents inflation. When actual growth falls to balanced growth, that is, below potential growth, the negative gap we see represents deflation, that is, the slump of the economy, or economic decline.

The third question is how to iron out this economic fluctuation

  Let the actual growth trajectory follow the long-term path of balanced growth as much as possible, so that the economy can maintain continuous, stable and long-term balanced growth, and continuously accumulate wealth. How to achieve it? Adoption of economic policies. What is the ultimate purpose of economic policy and economic intervention? It is about bridging the gap between real economic growth and balanced economic growth.

  This ironing process has led to differences in genres. Is monetary policy or fiscal policy a laissez-faire market economy. Do you think that the market economy itself has a convergence project that can achieve a return between actual economic growth and balanced economic growth, or is it possible to iron out economic fluctuations and cycles through economic policy intervention? This led to huge differences. So there was what we saw, from classical school to Keynesian school to the new classic that dominates the entire world of macroeconomic theory today.

Two economic worlds

  Based on this framework, we can say that there are two economic worlds. In other words, what we have seen so many books is actually presented to readers and researchers, that is, two economic worlds. One is the Keynesian economic world, which is completely true in the short term. Because in the short term, supply won't change much, or if it changes linearly, the probability of a shift is very small.

  So in Keynes's economic world, he made a very simple assumption for his research. What is this simple assumption? That is, the supply side is a straight line. What determines all the activities of the economy? It is determined by aggregate demand, so Keynesian economics is also called demand economics. When I was in my master's degree program, I basically taught Keynesian economics in textbooks.

  But it probably won't go too far into the first question, which is what is the long-term source of economic growth? We won't ask the question of how the supply side is structured. Including various analysts who are engaged in business research, I think what the vast majority of people know is actually the Keynesian economic world. Supply is a straight line. It is immobile, and economic fluctuations are entirely determined by demand.

  So in the world of Cairns, the inflation we see is all cyclical, why? Because of incentives and incentives through monetary and fiscal policy expansion, aggregate demand rises, and there is a positive output gap between supply and potential growth. What is this output gap? It's cyclical inflation.

Liu Yuhui: “A Perspective on the Macro Chess Game” -- The Key to Understanding Global and Chinese Macroeconomic Operations -2

  Everyone must understand that supply may be linear and immobile in the short term. However, if the time period is extended, supply will enter a non-linear state at some point in a long history of growth. The so-called nonlinear state means that its second-order derivative is not equal to zero; it can even be greater than zero or less than zero. The real world is like that sometimes.

  What results will we see? The second-order derivative of supply is likely to be less than zero, or even decline. Between falling supply and aggregate demand, there will also be a positive output gap. This output gap also corresponds to inflation.

  But the nature of this inflation is completely different from the nature of the inflation we see in the Keynesian economic world. It's not cyclical, it's structural. The reason for this is not that the expansion of aggregate demand stimulates a positive gap, but rather that supply is in a non-linear state, where it falls, and pulls a gap between enduring demand. The rise in prices and inflation that occur during this economic downturn is called stagflation from the perspective of economic mechanisms.

  I've been explaining to everyone. I'm saying that in economics, whether it's inflation, deflation, or stagflation, I'm talking about an economic mechanism; it definitely doesn't correspond to specific indicators. However, in actual business research, analysts often map this stuff to specific indicators, so that everyone's thinking is confined to an inertial framework. Speaking of inflation, the corresponding one is CPI, or PPI. I think this completely goes against the mechanism of economics itself.

Macroeconomic production function

  However, anyone who has studied macroeconomics will definitely be familiar with the production function. Let's explain this production function graphically.

  We know that a few years ago, there was a popular documentary called “China on the Tip of the Tongue.” It conveys Chinese cooking culture to everyone in a special way. As an image, we can think of supply as a pot. What is this pot called? It's called a production function. What is it talking about? It tells a story on the tip of the tongue. What goes into this production function? All kinds of ingredients, what are these ingredients equivalent to? Equivalent to various elements of this production function, such as labor, land, capital... , enter this pot with their own quantity and price. There are also various recipes. Flavors on the tip of the tongue require recipes and recipes. What is the equivalent of various recipes and condiments?

  It is equivalent to α in the production function, that is, various technologies and systems are gradually added. What was the final taste of a pot that was presented to everyone? Potential growth. Therefore, if you establish a certain sense of image and connect it to life, something that may seem boring will become very simple.

  Demand is the purchasing power achieved through monetary credit, which is the troika we are talking about. Investment, consumption, and net exports (net exports) is overseas demand. If demand surpasses supply, creating a positive output gap, everyone knows this is called inflation.

  Generally, demand takes the initiative to run above supply through the creation of prosperous monetary credit. However, there are also situations where our pot is broken, rusted over time, and the mineral composition in the pot has changed; or the ingredients in this pot are not fresh and aging; or the recipe has failed or the seasoning has expired. In other words, there are problems with technology and systems, leading to a sharp rise in system costs. For example, when the country moves in and people retire, it just doesn't taste like mom.

  After this pot failed, supply began to fall. Demand was still that demand. A gap between demand and supply was passively torn between demand and supply due to the decline in supply. Inflation will also occur at this time. In the economy, this state of affairs is called stagflation.


This issue's guests

Liu Yuhui is a professor of economics at the Chinese Academy of Social Sciences, doctoral supervisor, and chief economist at Tianfeng Securities.

Research interests: macroeconomics, international economics, financial markets and commercial banking.

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Liu Yuhui: “A Perspective on the Macro Chess Game” -- The Key to Understanding Global and Chinese Macroeconomic Operations -3

Disclaimer: The above content does not constitute any act of financial product marketing, investment offer, or financial advice. Before making any investment decision, investors should consider the risk factors related to investment products based on their own circumstances and consult professional investment advisors where necessary.

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