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Xu Gao's "Twenty Lectures on Macroeconomics"#

Xu Gao worked at Everbright Securities before, having served as a senior economist at UBS Securities, an economist at the World Bank, a part-time economist at the International Monetary Fund, and a research assistant. He is also a council member of the Chief Economists Forum in China and an advisor to the World Bank.
He joined Everbright Securities Co., Ltd. in May 2011 as the chief macro analyst.
In 2014, he became the chief economist at Everbright Securities.
In 2016, he served as the chief economist of Everbright Asset Management Co., Ltd.
In 2018, he was transferred to the chief economist of Everbright Asset Management.
In May 2019, he was appointed as the assistant president and chief economist of Bank of China International Securities.

"Twenty Lectures on Macroeconomics: A Chinese Perspective" is a lecture that analyzes current macroeconomic phenomena in China through the lens of macroeconomic ideas and theories.#

1. "Chinese Perspective" and "Macroeconomics"
   The "Chinese perspective" has two layers of meaning.

The first layer means that this lecture focuses on the Chinese economy as the subject of analysis. Is there structural imbalance in the Chinese economy? What should be the relationship between structural adjustment and stable growth? Is China's debt too high, and will it lead to a debt crisis? Has China issued too much currency, and is there a phenomenon of excessive currency issuance? Is there a real estate bubble in China?

The second layer means that the lecture selects macroeconomic ideas and theories to be introduced based on the study of the Chinese economy, and elaborates on the theories around the analysis of the Chinese economy.
This lecture fully embraces general equilibrium theory and rejects ad hoc models. An ad hoc model is one that assumes specific quantitative relationships between macroeconomic variables.

• Theoretically, the quantitative relationships between macro variables are unstable, and changes in the behavior of micro residents and enterprises can make these relationships disappear (for example, the disappearance of the Phillips curve).

Core ideas of the Phillips Curve:
Inverse relationship: When the economy approaches or reaches full employment (low unemployment), the labor market tightens, and companies will raise wages to recruit and retain employees, leading to rising inflation.
Trade-off between inflation and unemployment: Policymakers can choose between low unemployment and high inflation or high unemployment and low inflation within a certain range.

When we abruptly present a money demand function, the view directed at these deep economic forces will be blocked by the exogenously set functional relationships. Analyzing the economy in this way will always encounter some "mysterious" black boxes that hinder thinking from penetrating the fundamental logic of economic operation.

Only by grasping these ideological currents that influence people's thinking can we delve into the depths of policy debates and touch upon the deepest causes of macroeconomic phenomena.

The acceptance of the economic ideas behind macroeconomic theory is so widespread that it has become an unspoken premise of mainstream Western economic theory. However, because of this, these assumptions have also delineated the boundaries of the applicability of mainstream theory. China is a transitional economy, and its market operation has many characteristics that differ from the West, with many aspects that do not conform to the premise assumptions of mainstream Western macroeconomics.

2. Two Perspectives

The lecture organically combines the "water" and "stone" perspectives to integrate the Chinese perspective with macroeconomic analysis methods:

"Water" represents the operating laws of a market economy. Ideally, a market economy is as flexible as water—whatever shape the container holding the water is, the water takes that shape. The operation of China's market economy is still constrained by many remnants of a planned economy.
"Stone" represents the constraints faced by market operations. If we cannot see how the stones in the river obstruct the flow of water, we cannot understand why the river is so turbulent.
Just as water is water wherever it is, the basic laws of market economy operation are the same everywhere. However, under different constraints, the phenomena presented by the laws of market economy operation may vary significantly. Therefore, it is essential to combine the real constraints of China to deduce the operating characteristics of the market under these constraints.

3. Three Clues
   The lecture uses three main clues to string together the analytical models of macroeconomics, organizing them into a unified framework for understanding the Chinese macroeconomy.

Structural Imbalance in the Chinese Economy:

In theory, consumers weigh between consumption and investment. If investment is already too high, lowering the return on investment, consumers will allocate more income to consumption rather than investment—thus automatically forming an optimal allocation of resources between consumption and investment.

The biggest "stone" in the Chinese economy is the lack of a market mechanism to adjust consumption and investment. There are many savers in the Chinese economy who do not consume. They are not sensitive to the return on investment and are less likely to reduce their investment due to a decline in investment returns. Thus, the market mechanism that adjusts investment fails, leading to an imbalance of excess investment and insufficient consumption. Moreover, since investment projects lead to an expansion of production capacity after completion, excess investment naturally evolves into excess capacity. In the context of excess capacity, insufficient demand becomes a bottleneck for long-term growth in the Chinese economy.

Blockage of the Transmission Path of China's Monetary Policy:

Most macroeconomic textbooks assume that the transmission path of monetary policy is completely smooth—once money is issued, it flows smoothly into every corner of the economy.
In the Chinese economy, the flow of money faces many obstacles and frictions, resulting in a non-uniform distribution of money in the economy. This causes differences in liquidity conditions in different parts of the economy.

Historically, around 1500 AD, China surpassed India to become the world's largest economy, maintaining this status until the early 19th century. Before the Opium War, the Chinese economy accounted for about one-third of the world economy, making it the largest economy in the world. The Opium War opened a humiliating modern history for China, leading to significant changes in the economic situation. China's share of the world economy continued to decline, reaching a low of about 3% before the reform and opening up, a staggering drop. At the same time, the rise of the United States shifted the global economic throne in the 19th century. By the end of the 19th century, the U.S. economy surpassed China's, and throughout the 20th century, U.S. GDP remained the highest in the world. After the reform and opening up, the Chinese economy entered a fast lane, rapidly growing in scale, and around 2010, China's GDP (calculated at purchasing power parity) surpassed that of the U.S. Even when calculated at market exchange rates, China's GDP is expected to exceed that of the U.S. by 2030. The Chinese economy has experienced a fall and a rapid rise, a phenomenon that has never occurred in history. Therefore, we live in such an era, experiencing a period that will surely be remembered in human history during our youth, and standing at the center of events is fortunate.

Economic Methods for Analyzing China's Economic Issues

Supply and Demand Curves

• 1. Supply and Demand Analysis—Taking China's Real Estate Economy as an Example. About 80% of China's investment consists of real estate investment, infrastructure investment, and manufacturing investment. In recent years, the growth momentum of infrastructure investment and manufacturing investment has declined, while real estate investment has driven overall economic growth, becoming the most important part of it. Further observation of the appreciation rate of housing prices and housing sales area shows a close positive correlation between the two, and the growth rate of housing sales area changes precede the changes in housing prices. Thus, the conclusion is drawn: the price fluctuations of China's real estate are mainly influenced by demand factors. The main reason for this situation stems from China's land policy: land supply is limited, and prices mainly change due to demand-side fluctuations. Therefore, the government cannot regulate housing prices through supply-side reform plans of "price drop and quantity increase," but can only do so through demand-side reform plans of "price drop and quantity drop" or "price increase and quantity increase." Combining the ultimate goal of "controlling housing prices" and the actual factors of real estate investment driving economic growth, the government needs to find a balance between the two. When residents believe housing prices are too high, the government can control housing prices through demand-side measures, such as tightening financing; when housing prices are relatively low, the government can stabilize housing prices to ensure that real estate investment drives economic growth. (Refer to slides p26-29)
• 2. Supply and Demand Analysis—Taking Pork Prices as an Example. In recent years, there has been a significant divergence between the CPI and PPI change rates in China, with CPI inflation occurring simultaneously with PPI deflation, resulting in consumers perceiving prices as increasingly expensive while manufacturers perceive them as increasingly cheap. In fact, CPI inflation almost entirely stems from the rise in pork prices. Analyzing the volume of live pigs and pork prices reveals a clear negative correlation, with changes in the volume of live pigs slightly preceding changes in pork prices. Thus, the conclusion is drawn: pork price inflation is mainly influenced by supply-side factors. Therefore, demand-side reform plans will not have a significant impact on pork purchasing. Currently, pork prices are based on supply-side changes, resulting in "price rise and quantity drop" or "price drop and quantity rise." The government's monetary policy will not affect the pork inventory and cannot reverse the current situation where consumers generally believe pork is too expensive. In the long run, the current situation of pig farming will not have a positive impact on pork price trends. The number of live pigs and the replenishment rate are far below the outflow rate. It can be anticipated that pork prices will further rise in the future.
• 1. Structural Imbalance: Insufficient Consumption;
• 2. Monetary Policy Transmission Path: Looking at the distribution of money through the total money supply;
• 3. The Debate on Say's Law: Orthodox Adam Smith, Hayek vs. Unorthodox Keynes, Malthus, Marx;

1. The Origin and Influence of Current Mainstream Macroeconomics (New-New Classical Synthesis)
   

1. The Opportunity from "Classical Theory" to "New Classical Synthesis": The Great Depression of 1929

Classical economists: The market operates efficiently.

Keynes and Samuelson: The market may not be as efficient as classical economists believe; the Great Depression proved that the market can fail severely, and the market and government must work together. When the market fails, the government can guide the market back to effective operation through macro-control policies.

2. From "New Classical Synthesis" to "New-New Classical Synthesis": Stagflation

In the 1970s, the emergence of "stagflation," where economic growth stagnated alongside high inflation, triggered the "rational expectations revolution." Economists realized that people's behavior changes due to changes in their surrounding environment, making the relationships between macroeconomic variables unstable; that is, the public's rational response to macro policies can render policies ineffective, and economic cycles are the optimal response of the market to technological shocks; economists regained confidence in the market, believing that macro policies should be limited to the short term.

3. The Theme of the Development of Macroeconomic Thought: The Relationship between Market and Government

4. The Impact of the New-New Classical Synthesis Worldview on the Chinese Economy

Currently, the biggest debate regarding the Chinese economy is how much the government should allow the decline in economic growth and to what extent it should use fiscal and monetary policies to support economic growth.
During the "4 trillion stimulus policy" and the following years, this debate manifested as a conflict between "adjusting structure" and "stabilizing growth," and later as a conflict between "supply-side" and "demand-side."

Critique of New-New Classical Economics on Chinese Macroeconomic Policy 1: It believes that the slowdown in China's economic growth is due to the decline in potential output levels, represented by the "end of the demographic dividend theory."

Critique of New-New Classical Economics on Chinese Macroeconomic Policy 2: China will experience a debt crisis. Proponents of this view believe that the scale of debt on the debtor side is too high, which will inevitably lead savers to stop lending to it, resulting in a debt crisis. However, China's high debt is caused by the economic structure of excess savings, and before the economic structure is adjusted, suppressing the expansion of debt will only destabilize the real economy. At the same time, policies that suppress the conversion of domestic debt into domestic investment have instead strengthened the motivation of financial institutions to evade regulation, leading to the creation of new channels, thus triggering a series of chaotic phenomena in the Chinese economic system after the subprime mortgage crisis.

Questioning the "New-New Classical Synthesis" and further critiquing it

2. The Challenge of the Subprime Mortgage Crisis to the "New-New Classical Synthesis"

1) Challenges from Three Aspects:#

Difficult to Explain the Occurrence of the Subprime Mortgage Crisis: In the "New-New Classical Synthesis," the financial system is absent, or rather, finance is positioned at the periphery. In the "New Keynesian" model, the entire financial system is only summarized by a "nominal interest rate," but during the subprime mortgage crisis, the financial system was the "epicenter" of the crisis.

In the post-crisis era, the operation of the global economy and the application of macro policies cannot be satisfactorily explained by the "New-New Classical Synthesis." The "New-New Classical Synthesis" believes that the market will, in the long run, let resources be allocated most efficiently, and deviations from the effective state only exist in the short term; correspondingly, macroeconomic policies can only be effective in the short term and can only be implemented in the short term. However, in the post-crisis era, the long-term adjustment mechanism of the market has not been effective, leading to prolonged global economic stagnation.

The "New-New Classical Synthesis" lacks explanatory power regarding the main characteristics of the world economy before and after the crisis, such as "global imbalances" and the various results that followed. To a large extent, the U.S. real estate bubble that triggered the subprime mortgage crisis stemmed from global excess savings, but in the post-crisis era, global excess savings evolved into a lack of global aggregate demand, trapping economic growth in prolonged stagnation. Within the framework of the "New-New Classical Synthesis," the belief in the market's efficient adjustment power means that there is no occurrence of excess savings and insufficient demand.

2. Conclusion: The various economic practices after the subprime mortgage crisis do not conform to the "New-New Classical Synthesis," and the gap between this framework and the real world is widening. Based on the previous notes on the Chinese economy (insufficient consumption caused by state-owned enterprises), we understand that the market adjustment mechanism assumed by neoclassical economics does not manifest in the reality of the Chinese economy.

3. Discussion on the Chinese Economy#

1. In the past decade, the polarization tendency of the Chinese economy has been very obvious.

The cycle of "release to activate, activate to chaos, chaos to control, control to death" is evident.

It has been described by Song Guoqing as the "ping-pong ball" of economic operation—economic operation is converging towards the extremes of "overheating" or "overcooling," being pushed back to the middle area by macro policies, rather than fluctuating around the potential output level.

Currently, the Chinese economy is converging towards the "overcooling" extreme, with output below the potential output level.

2. There is a need to create demand through expansionary aggregate macro policies to stabilize economic growth. Allowing economic growth to decline will lead to an economic crisis characterized by overproduction—similar to the years from 1998 to 2002.

3. The three paths for the Chinese economy:

Best strategy: Major reforms beneficial to income distribution for residents, effectively promoting consumption transformation.

Moderate strategy: Before income distribution reforms are implemented, continuously stimulate aggregate demand through expansionary aggregate macro policies to stabilize growth.

Worst strategy: If income distribution reforms are not made, and aggregate macro policies do not stimulate aggregate demand, China will drag the entire world into an economic crisis—China is already a major country with significant spillover effects on the global economy.

4. Understanding the Six Layers of Thinking in the Chinese Economy

1) First Layer of Thinking: GDP-Only Theory#

"Development is the hard truth."

Clarified the direction of work.

Established the status of "development" (using development to solve problems encountered during development), bringing significant returns to China.

In practice, development often focuses on GDP, forming a "GDP-only theory."

Simple and clear, easy to implement.

Local government GDP competitions have made the government a "supportive hand" rather than a "predatory hand" in the economy.

GDP is the best economic statistical indicator related to national welfare.

2) Second Layer of Thinking: Naive Market School—The Impact of the New-New Classical Synthesis Worldview on the Chinese Economy#

The relationship between "development" and "marketization."

Since the reform and opening up, development has been the goal, and marketization has been the means, with no contradiction between the two.

In the post-crisis era, the downward pressure on economic growth has increased, and development increasingly relies on government-led stable growth policies, leading to contradictions with market-oriented directions.

Naive market advocates believe that current problems mainly stem from insufficient marketization.

They believe that the "old road" style of stable growth delays (or even hinders) the advancement of marketization.

They believe that economic structure should be adjusted through market clearing.

They view the market as a goal, creating an imperceptible yet significant gap with the guiding principle of "development is the hard truth."

3) Third Layer of Thinking: Realism (Suboptimal Theory Perspective)#

Suboptimal theory (Lipsey, Lancaster, 1953).

Optimal market economy requires a series of preconditions to be guaranteed.

When the preconditions cannot be met simultaneously, having more preconditions does not yield better results.

Finding the suboptimal often requires specific analysis of specific situations.

Suboptimal theory is the theoretical basis for the two approaches of the Eastern European transition.

Shock therapy.

Gradual reform.

The structural imbalance of the Chinese economy is rooted in income distribution.

The income distribution structure determines the insufficiency of private demand (especially private consumption) in the demand structure.

Before the income structure is adjusted, allowing the attempt of "market clearing" can only lead to a hard landing of the economy.

The "old road" to stabilize growth is a suboptimal choice, similar to the "GDP-only theory," using stimulus policies to stabilize GDP growth, but having already experienced a denial of denial, the cognition has already improved.

4) Fourth Layer of Thinking: Realistic Market School#

Through realistic market-oriented reforms to escape the "suboptimal."

Market-oriented reform is a process where the real constraints faced by the market are continuously exposed and resolved.

The pain of economic conditions sliding from "suboptimal" to "next optimal" points out the true constraints that restrict the success of marketization.

Analyzing problems realistically and relaxing constraints steadily is the only way to continuously promote marketization.

The difference between realistic marketization and utopian marketization.

Realistic marketization: Viewing the pain of reform as a signal to discover key constraints.

Utopian marketization: Ignoring the signals released by the pain, naively believing that as long as the reform continues, the pain will disappear, resulting in prolonged pain.

Examples:

Interest rate marketization reform: Distortion of financing platforms—clearing of financing platforms—replacement of local debts.

5) Fifth Layer of Thinking: Chief Designer Thinking#

Is the breakthrough of key constraints accidental or inevitable?
An analogy:
A child goes missing in a mountain village, and the whole village searches for him. Eventually, the child is found. Where the child was found and who found him is an accidental event.
However, the result of finding the child is inevitable (clear goals, systematic search project).
The essence of the success of China's reform and opening up.
"Development is the hard truth."
"Crossing the river by feeling the stones."

6) Sixth Layer of Thinking: Road Confidence#

The first five layers of thinking reflect a gaze upwards towards the West—transforming China according to Western standards (checking off China according to Western standards).
It reflects the West's leading position over China in many aspects (military, technology, politics, culture) and reflects a lack of confidence in China.
We must recognize the strengths of the Chinese model.
Insufficient savings bring capital cost advantages to China.
The positive role of state-owned enterprises.
Different eras call for different spirits of the times—China's rise will inevitably restore China's confidence.
Not all differences between China and the West are deficiencies; some are merely differences, and some are even better.
Replace inferiority with confidence, but do not turn confidence into arrogance.

Introduction to Financial Economics and Basic Discussion Issues

• 1. Definition of Financial Economics: Financial economics is a branch of economics that studies finance. Economics allocates resources, and finance, as a branch, studies the allocation of financial resources.
     Among them, "the future" is closely related to two factors—one is "intertemporal," and the other is "uncertainty."

The trading of financial assets always occurs between the supply and demand sides of funds. The supplier invests in the demander to obtain financial assets, becoming the asset buyer; the demander correspondingly becomes the asset seller and provides returns to the supplier in the future. However, financial transactions and supply and demand always begin with human behavior. More specifically, it is the dynamic behavior of people under uncertainty.

3. Theoretical Basis of This Course: Generally speaking, "positivity" can be derived from supply and demand. For example, when supply is positive, it is the asset supply side; when supply is negative, it is the asset demand side, and vice versa. Therefore, there is no clear boundary between the two sides.
   However, when the asset seller is a company, the situation differs from that of individuals. To explore the demand for funds and assets by companies, we use "corporate finance" theory.

Corporate finance theory is the discipline that studies corporate financing, investment, and risk management, with the main goal of optimizing corporate financial decisions to maximize corporate value. Here are some key corporate finance theories and concepts:

• 1. Modern Portfolio Theory (MPT)
     Concept: Proposed by Harry Markowitz, it emphasizes reducing the risk of an investment portfolio through diversification. This theory shows that investors can optimize the trade-off between expected returns and risk by combining assets.
     Key Points:
     The risk and return of assets can be reduced through diversified investments.
     Expected returns are associated with the risk (standard deviation) of the assets in the portfolio.
• 2. Capital Asset Pricing Model (CAPM)
     Concept: CAPM is a model that describes the relationship between expected returns of an asset and market risk.

Studies the financial economics of individuals and enterprises.

• The first methodology is supply and demand equilibrium, starting from people's supply and demand psychology. The advantage is that it establishes asset prices from nothing, while the disadvantage is that many assumptions must be made to find equilibrium, thus slightly reducing accuracy.

• This leads to the second methodology. The second methodology is non-arbitrage pricing, which infers the prices of other assets from known asset prices.

• The third methodology is financial friction, such as information asymmetry, which can make financial transactions impossible and affect transaction outcomes.
  In addition to the first three, we will also briefly discuss market efficiency. Based on the theory of Nobel laureate economist Robert Shiller from 2013, markets are inefficient. Therefore, behavioral finance was established to explore the irrational behavior of both supply and demand sides.

As shown in the figure, the famous "asset pricing problem" is to explore how the current asset P should be priced given future returns Xu, Xd, and their respective probabilities q, 1-q.

6. Since the probabilities q, 1-q corresponding to Xu, Xd are unknown, we can only estimate future asset returns by calculating the "expected asset return rate."

1. Key Issues Regarding the Chinese Economy#

1. Supply and Demand Analysis

① Taking the real estate market as an example.

② Taking the pork market as an example.

Inflation trends diverge: consumer inflation, producer deflation. CPI mainly comes from pork.
Negative correlation: Pork prices are influenced by supply.
Monetary control demands it, so there is no reason to tighten the currency; the currency should be allowed to flow, according to the price department of the National Development and Reform Commission.

Economic research aims to uncover the real individuals behind the economic numbers.

The language of supply analysis is a vague trap: the apple paradox.

It is essential to clarify the concepts: demand arises from the preferences expressed by health experts, the demand curve extrapolates, and transaction prices rise; while the second statement indicates that the clearing point shifts under unchanged demand curves; thus avoiding meaningless debates.

1. Key Issues in the Chinese Economy#

• Purchasing Power Parity (PPP) is a method of calculating the equivalence coefficient between currencies of different countries based on different price levels, to avoid the interference of market exchange rate fluctuations and to evaluate the economic scale of each country more reasonably. Compared to calculations based on market exchange rates, the economic scale calculated using purchasing power parity will be larger for China.

• The middle-income trap is a term created by the World Bank to describe the phenomenon where a country enters a middle-income level, but the cheap labor and other factors that supported rapid economic growth in the past gradually disappear, leading to a slowdown in economic growth. If this country cannot find other sources of growth, its income level will stagnate at the middle-income level for a long time, as if it has fallen into a trap.

• The population issues facing China: The middle-income trap is just one of the economic growth issues we need to worry about. The family planning policy vigorously promoted after the reform and opening up has profoundly changed China's population structure, leading to a rapid arrival of an aging society. With the proportion of the working-age population declining, there are concerns that the end of the demographic dividend will lead to a decline in China's economic growth. The increasing proportion of elderly people in the population also raises concerns that China may grow old before it becomes rich, leading to a series of economic and social problems.
  The consequences and measures of low resident consumption: The low proportion of resident consumption has brought two adverse consequences.

First, since consumption is the main way for residents to enhance their utility, a low consumption proportion means that the fruits of China's economic growth have not been fully transformed into improvements in residents' welfare.

Second, since consumption and investment together constitute the internal demand of an economy, a low consumption level means a high investment proportion. Investment will ultimately lead to an expansion of production capacity. Thus, the imbalance between ultimate demand (consumption) and production capacity in the Chinese economy becomes increasingly prominent, ultimately forming a pattern of insufficient demand and excess capacity. This is the main reason for the sluggish growth of China's economy after the subprime mortgage crisis. In response to this situation, the Chinese government has proposed a policy direction for consumption transformation, hoping to increase the proportion of consumption in GDP and shift China's economic growth model from investment-driven to consumption-driven.

2. Economic Methods for Analyzing China's Economic Issues
   CPI and Pork Prices: The fluctuation of pork prices has a significant impact on CPI. CPI stands for "Consumer Price Index," which reflects the average change in prices of a basket of goods, indicating the overall price change faced by consumers. In the CPI basket, pork accounts for nearly 3%, making it the largest single commodity. The fluctuation of pork prices is also very volatile, with annual increases often exceeding 50%. Thus, due to the large proportion of pork in the CPI basket and its volatile price fluctuations, the inflation pressure of CPI often mainly comes from pork. Some jokingly say, "CPI inflation is anxiety triggered by a piece of pork." (Refer to slides p30-34)

Glossary:#

• IMF: International Monetary Fund
• Purchasing Power Parity: The exchange rate determined by the relative prices of the same set of goods
• Middle-Income Trap: A process where per capita GDP suddenly turns negative after a period of growth, followed by a gradual recovery.
• Li Keqiang Index: A more objective and realistic reflection of local economic conditions, averaging credit, electricity generation, and railway freight volume.
• M2: Broad money supply
• Monetary Policy: (Excerpt from Baidu Encyclopedia) Monetary policy refers to the various policies and measures adopted by the central bank to control and adjust the money supply and credit volume to achieve specific economic goals.
• Local Government Financing Platform: Also known as urban investment companies, refers to state-owned enterprises established by local governments, usually obtaining financing from financial markets and investing in infrastructure projects, such as a city's subway company.
• ROA: (Excerpt from Baidu Encyclopedia) Generally refers to Return on Assets. ROA = Net Profit After Tax / Total Assets

Using mathematics to analyze the reasons for economic issues: Once the deductions are expressed in mathematical language, the ambiguities in thinking become apparent. This way, many confusions and disputes arising from the imprecision of natural language can be resolved. Moreover, once theories are expressed mathematically, complex logical reasoning can be completed through mathematical deductions, making it easier to find conclusions. Due to the clear advantages of mathematical language in precision and reasoning convenience, economics has become deeply mathematical in recent decades. This mathematicalization has, in turn, led to significant development in economics. However, it is essential to remember that mathematics is merely a tool; our true goal is to find answers to real-world problems. A beautifully written mathematical formula does not mean that the problem is answered well. The most important thing is the economic logic presented by mathematics. It can be said that mathematics is just our boat to cross the river. After we have clarified our thoughts using mathematical tools, we should be able to completely abandon mathematics and explain the logic in plain language that is convincing. Only in this way can the problem be considered genuinely solved.

• Purchasing Power Parity (PPP) is a method of calculating the equivalence coefficient between currencies of different countries based on different price levels, to avoid the interference of market exchange rate fluctuations and to evaluate the economic scale of each country more reasonably. Compared to calculations based on market exchange rates, the economic scale calculated using purchasing power parity will be larger for China.

• The middle-income trap is a term created by the World Bank to describe the phenomenon where a country enters a middle-income level, but the cheap labor and other factors that supported rapid economic growth in the past gradually disappear, leading to a slowdown in economic growth. If this country cannot find other sources of growth, its income level will stagnate at the middle-income level for a long time, as if it has fallen into a trap. The population issues facing China: The middle-income trap is just one of the economic growth issues we need to worry about. The family planning policy vigorously promoted after the reform and opening up has profoundly changed China's population structure, leading to a rapid arrival of an aging society. With the proportion of the working-age population declining, there are concerns that the end of the demographic dividend will lead to a decline in China's economic growth. The increasing proportion of elderly people in the population also raises concerns that China may grow old before it becomes rich, leading to a series of economic and social problems.

• The consequences and measures of low resident consumption: The low proportion of resident consumption has brought two adverse consequences. First, since consumption is the main way for residents to enhance their utility, a low consumption proportion means that the fruits of China's economic growth have not been fully transformed into improvements in residents' welfare. Second, since consumption and investment together constitute the internal demand of an economy, a low consumption level means a high investment proportion. Investment will ultimately lead to an expansion of production capacity. Thus, the imbalance between ultimate demand (consumption) and production capacity in the Chinese economy becomes increasingly prominent, ultimately forming a pattern of insufficient demand and excess capacity. This is the main reason for the sluggish growth of China's economy after the subprime mortgage crisis. In response to this situation, the Chinese government has proposed a policy direction for consumption transformation, hoping to increase the proportion of consumption in GDP and shift China's economic growth model from investment-driven to consumption-driven.

• The key issues regarding the Chinese economy's demand side: The first judgment, which does not include value judgments, is a statement of objective facts (is): The proportion of resident consumption in GDP in China is significantly lower than the world average. The savings rate in China is significantly higher than the world average. The second judgment, value judgment (should): Is the proportion of resident consumption (should) too low? When posing such a question, it already contains a value judgment. Is China's savings rate too high? When saying it is too high, there is an internal standard for how high it should be, and the current savings rate exceeds that standard. Whether there is insufficient consumption and excessive savings in China: this is a more obvious value judgment. Whether the proportion of consumption and savings in China is appropriate: this still carries a value judgment. From the actual to the should (from David Hume onwards): a low proportion of resident consumption does not necessarily mean that consumption is insufficient, nor does it mean that consumption is necessarily sufficient.

The key question: What should the proportion of consumption in China be? What should the savings rate in China be? The answers to these two questions provide a more realistic benchmark. The standard for judging this "should" is welfare, that is, whether it is conducive to the improvement of the welfare of all residents in society.

10.2 Key Issues Decomposed#

The standard for judging "should" is utility (welfare): The goal of consumers is to maximize utility, but this statement is very vague. The maximization of utility has different meanings in different contexts. What kind of utility is it: The study of macroeconomics must be conducted in the time dimension, considering both present and future. Therefore, it is essential to establish the time point, whether it is today or the future, for maximizing utility. How does the maximization of utility relate to consumption and savings behavior? What conditions must be met for optimal consumption and savings behavior to maximize consumer utility?

11. Understanding Consumption and Savings Decisions from the Perspective of Consumers (Residents)#

This is the manifestation of studying macro phenomena from a micro foundation. We should analyze macroeconomic phenomena from the micro decisions of individual consumers. Consumers have several grains of rice, which can either be eaten now (consumption) or saved for future use (savings), or planted to grow more rice (investment) for future returns.

Consumers must maximize discounted utility and consider both current and future consumption. Since human nature is impatient, future utility must be discounted when compared to current utility—eating a bowl of rice today provides more utility than eating a bowl of rice in the future. Consumers must maximize the sum of discounted utility from current and future consumption.

Consumers choose consumption and savings behavior to maximize the sum of discounted utility. Since the marginal utility of consumption decreases in each period, consumption should be distributed smoothly across periods: It is better to consume similarly in both periods than to consume a lot now and starve in the future, or vice versa.

Consumers use savings to transfer consumption across different periods to achieve a smooth distribution of consumption. The purpose of savings is to emphasize the utility that future consumption can provide, and most people do not save for the sake of saving; rather, they weigh the trade-offs between current and future consumption. By saving, they adjust the distribution of consumption across different time points to maximize the total discounted utility over their lifetime. Increasing savings means transferring current consumption to the future, such as lending food to others, while decreasing savings means transferring future consumption to the present, such as borrowing food from others.

12. Evaluation Standards for Optimal Consumption and Savings#

The proportion of resident consumption in China is 30%, and the savings proportion is 40%. Is this proportion appropriate, and does it maximize the welfare of residents? To answer this question, we must first analyze what conditions need to be met to achieve optimal consumption and savings states.

12.1 Conditions: The Balance Between Consumers' Intertemporal Subjective Preferences and Savings Return Rates#

Marginally increasing savings brings two effects:

• Negative effect: Increasing savings means reducing current consumption, thus lowering the sum of discounted utility.
• Positive effect: Increasing savings leads to more future consumption (investment returns), thus increasing future utility and the sum of discounted utility.

When consumption and savings reach optimal levels, the marginal positive effect of increasing savings equals the marginal negative effect: When consumption and savings are indifferent, the optimal savings state is reached, maximizing discounted utility.

This is the marginal condition in microeconomics. The above equation is the Euler equation, which presents the optimization relationship when making intertemporal substitutions. It connects the current marginal utility (numerator) and future marginal utility (denominator) with the asset return rate and savings return rate. When savings are indifferent, the optimal state is reached. The optimal state is determined by two factors: one is subjective preference, whether there is patience, and the state of the subject; for example, if one has eaten enough apples today, the marginal utility of eating more apples is very low, thus the motivation to save will be strong; if one has not eaten anything today, the marginal utility of eating apples is very high, thus the motivation to save will be low.

The second is the objectively available return rate; for example, if delaying the consumption of one apple today allows one to obtain 100 apples tomorrow, the savings return is very high, thus the motivation to save will be strong. The final balance is the balance between subjective time preferences and the objective savings return rate.

If the two achieve balance, it indicates that the savings behavior is optimal, and since savings = income - consumption, consumption is optimal. Consumption and savings are two sides of the same behavior. This is the evaluation standard for optimal consumption and savings, which is the balance between consumers' intertemporal subjective preferences and objective savings return rates.

12.2 How to Use This Scholarly Condition to Evaluate the Real-World Consumption and Savings Situation?#

How can we observe consumers' intertemporal subjective preferences? This relates to how consumers evaluate current consumption versus future consumption, which is unobservable.
Investment is primarily made by enterprises, and how does the investment return of enterprises relate to consumers' intertemporal subjective preferences? This involves Fisher's separation theorem.

13. Answering the Two Questions: Intertemporal Subjective Preferences and Enterprise Investment Return Rates#

1. Market interest rates reflect consumers' intertemporal subjective preferences.

Assuming consumers' intertemporal subjective preference is: one bowl of rice today is equivalent to two bowls of rice in the future. In the first scenario, if the current market interest rate is 200% (one bowl of rice saved today can become three bowls of rice in the future), then the return rate is higher than expected, and consumers will increase savings and reduce current consumption, leading to a decrease in market interest rates. If others have the same expectation, they will also reduce consumption and increase savings. As savings increase, the return rate will decrease because savings come from investments, and the marginal return on investments decreases. Savings will continue to decrease until the market interest rate aligns with subjective preferences, at which point marginally, consumers will no longer have the motivation to increase or decrease savings, stabilizing the market interest rate.

In the second scenario, if subjective preferences remain unchanged while the market interest rate is 50% (one bowl of rice saved today can only become 1.5 bowls of rice in the future; borrowing one bowl today requires repaying two bowls in the future), this means that consuming one bowl of rice today requires repaying less than expected in the future, leading consumers to reduce savings and increase consumption. As savings decrease, the return rate will rise (market interest rates will rise), and savings will continue to decrease until the market interest rate aligns with subjective preferences. Therefore, the market interest rate reflects the average subjective preferences of consumers.

2. The possibility of dividends reflects the investment return rate of enterprises.

Generally, investment is the behavior of enterprises, while savings are the behavior of consumers. Why does the investment return of enterprises affect consumption and savings behavior? This involves the separation theorem of Fisher.

The investment decision of enterprises is also the decision of dividend distribution: 1st period output - 1st period dividends = 1st period enterprise investment (savings): the 1st period is now, and the 2nd period is the future. The 1st period output is given, and a portion must be distributed to shareholders as dividends (assuming all shareholders are consumers). The remaining portion of the 1st period output is the investment for that period.

The dividends in the 2nd period equal the output in the 2nd period: all output in the 2nd period is distributed as dividends. Therefore, in the case of given output in the 1st period, the investment decision of enterprises is equivalent to their dividend decision. Thus, enterprises can choose the investment in the 1st period to determine how much to distribute in the 1st and 2nd periods.

In the above, the boundary of dividend possibilities is the blue line, which is concave towards the origin. The horizontal intercept of this curve represents the situation where all output in the 1st period is distributed as dividends, with investment being zero, and thus the output in the 2nd period is zero. The other extreme is when no dividends are distributed in the 1st period, allowing for maximum dividends in the 2nd period.

The concavity of the curve reflects the diminishing marginal returns of investment. Near the blue line and the horizontal intercept, reducing a little of the 1st period's dividends can significantly increase the 2nd period's dividends because investment is low, and the marginal return on investment is high. Conversely, near the blue line and the vertical intercept, reducing a lot of the 1st period's dividends can only slightly increase the 2nd period's dividends because investment is already high, and the marginal return on investment is low.

Thus, the concavity of the curve reflects the diminishing returns of investment. The slope of the tangent line at any point on the dividend possibility boundary represents the marginal return on investment of enterprises. Consumers, as shareholders, will demand that enterprises maximize their utility by choosing the optimal dividend plan.

14.1 The Competitive Market of Enterprise Ownership Guarantees that the Investment Return Rate of Enterprises Equals the Market Interest Rate, as Well as the Subjective Time Preference of Consumers#

Consumers, as shareholders of enterprises, will demand that enterprises' investment decisions maximize their utility: A and B both hope their indifference curves are as high as possible, and the blue line is the boundary of dividend possibilities. The straight line represents the income situation that can be achieved by borrowing in the market.

For enterprises, the supply of 1st and 2nd period consumer goods is represented by the dividend possibility boundary and all points within that boundary. Rational individuals will seek the optimal dividend plan along the boundary because points within the boundary waste resources. However, this does not mean that consumers can only receive the amount of goods indicated on the blue line.

For example, residents can borrow from the market based on the dividends at a certain point, achieving a consumption plan along the line parallel to the straight line in the figure.

Enterprises' investment and dividend decisions must maximize the value of the enterprise's stock. The competitive market of enterprise ownership ensures that enterprises operate with the goal of maximizing their stock value.

Therefore, any point on the blue line can be borrowed in the market to adjust the consumption plans for the 1st and 2nd periods. Ultimately, the supply of consumer goods by enterprises is defined by the blue line, but the consumption plans that residents can achieve are based on the points along the line parallel to the straight line in the figure.

In summary, the optimal consumption/investment (savings) ratio in the real world is determined by two conditions: 1) The ownership of enterprises belongs to residents; 2) There exists a competitive market for enterprise ownership (capital market) to ensure that potential investors push for the dynamic return to equilibrium stock prices.

14.2 The Realization of Optimal Consumption/Investment (Savings) in the Real World#

The investment return rate of enterprises must equal the market interest rate, and the market interest rate must align with residents' subjective time preferences at equilibrium, forming an equivalence relationship between residents' subjective preferences and investment return rates. The realization of the optimal consumption/investment (savings) ratio in the real world requires the establishment of a market mechanism that flexibly adjusts the distribution of income between consumption and savings, with the core of this market mechanism being the capital market. The premise for this mechanism to function is that residents have ownership of enterprises and can influence the operational behavior of enterprises. Only then can the investment behavior of enterprises adjust according to residents' time preferences.

15. Summary of This Lecture#

This lecture is the most important argument of this semester. First, through the argument itself, we demonstrate the methodology we should use when analyzing macroeconomic phenomena. For example, in analyzing consumption and savings, we have consistently focused on the marginal decisions of micro-individuals, starting from an individual's optimal decision to analyze macro phenomena, and this methodology has been fully reflected in the argument.

Second, this lecture has established the most important benchmark for analyzing the structure of demand in the Chinese economy (regarding the proportion of consumption and savings). We often talk about insufficient consumption and excessive savings in China. When we state these points, we must carefully consider the basis for these arguments. Today, we have derived the benchmark for the proportion of consumption and savings. This is the starting point for analyzing the Chinese economy, providing a suitable benchmark to determine if the demand structure in China is optimal and appropriate. Next, we will analyze how the demand structure in China has deviated from the optimal state, the causes of this deviation, and its potential consequences.

In previous lectures, we discussed analyzing the Chinese economy from the perspectives of water and stone, where water represents the theoretical framework of the market economy, and stone represents the obstacles to the flow of the market economy. When we want to see the impact of stones, we must first understand how water should flow in the absence of stones and the smoothest conditions. Today, we have drawn this conclusion: the market economy situation that is most beneficial to improving the welfare of Chinese residents should be as described in this lecture. In the future, we will continue to analyze what happens when stones are present, making the impact of stones clearer. Today marks our first lecture on the demand side, which is the most important lecture. The content of this lecture must be carefully digested, and it is recommended to conduct a mathematical derivation of the lecture notes to elevate our understanding of the analysis of the Chinese economy and the reality of the Chinese economy to a new level.