Real Economy
The portion of the economy that produces goods and services for consumption.
What is the Real Economy?
The concept of real economy refers to the portion of the economy that produces goods and services for consumption. It predominantly deals with the production, purchase, and flow of goods and services within an economy.
These goods and services can include a number of normal and luxury goods like oil, bread, water, and labor. A real economy is the foundational stone of an economy, as people's lives depend on it.
The real economy comprises all its active components, excluding the financial and monetary elements used as intermediaries of trade, which form a key portion of a financial economy.
A financial economy is formed by the existence and predominance of money exchange transactions and financial assets. Financial economies are concerned with the exchange of paper assets like savings, stocks, and bonds.
The productivity of an economy is the ratio between the output and input volumes. It measures how effectively input parameters are utilized to produce a perceived level of output.
Output is specific to an industry and its market, generating a supply of goods and services as efficiently as the input enables it. Conversely, consumers facilitate a product's demand, forming our supply and demand model.
Labor is an essential input and resource for producing output. Workers are paid wages for their services. These wages are then used to purchase personal goods and services they require for survival (essential) or to accommodate their lifestyle (discretionary) Itially computes the average production value of each citizen in an economy.
Key Takeaways
- Real Economy refers to the tangible, productive sector of an economy that produces and distributes goods and services.
- The real eactualmy plays a fundamental role in driving economic growth and development by creating jobs, generating income, and fostering innovation.
- The performance of the real economy directly influences living standards by determining the availability and affordability of essential goods and services.
- While the real economy focuses on the production and exchange of physical goods and services, the financial economy deals with the management of monetary assets and capital markets.
Real Economy And Bartering System
The real economy refers to the purchase, production, and flow of goods and services in an economy. A barter economy or barter system is an example of an economy where financial transactions (transfer of paper) are non-existent.
A barter system is part of a real economy, where there is always an exchange of goods and services for goods and services. This is unlike a financial economy, where there are deal transactions encompassing currency transactions and financial assets.
The bartering system was a method of trading goods and services before the monetary system came about. It was a sustainable method of trade. However, in practice, it would have restricted how far humans could have progressed.
A real economy includes real variables like wages, which can be expressed in real terms. For example, a laborer might be compensated with two dozen bananas for one hour of labor. It may also include an exchange of goods, like 1 kilogram of meat for 3 kilograms of wheat.
The deal was successful, but this "coincidence of wants" rarely occurs. Firstly, the baker would have to find a plumber willing to take bread as payment for their services.
The likelihood of finding a suitable trade partner is low, requiring people to hoard items that could be useless to them but may be helpful to others. Moreover, the trading process could take months before something useful is obtained.
Bartering worked so well in the past because goods were confined to essential items for survival and were traded in bulk between smaller populations.
Bartering is impractical in the modern age. However, it can be used if a country's currency becomes worthless due to political or economic crises, such as hyperinflation. In this scenario, large quantities of bartering could be helpful for trading locally or internationally.
The monetary and financial system
The monetary and financial systems are key components of the same larger economy. Collectively, they are responsible for issuing and circulating currency, as well as managing financial assets and liabilities.
Monetary and financial systems are closely related and linked to the international monetary system. Within this international monetary system, foreign exchange rates, international trade, and capital flows are created and managed. Balance-of-payments are part of the very same international monetary system.
Monetary System
A monetary system and its components are responsible for issuing and circulating money. Here, the word "Money" includes currency, demand deposits, and other financial assets that can be transferred with little or no loss in value.
The monetary system has transitioned over the centuries, with "commodity money" initially succeeding the bartering system. Then, metals with different levels of intrinsic value, such as gold, silver, and copper, were used as currency.
Physical money, implemented as an intermediary of trade, relieved the complexities of bartering.
Accepting a universal item of value to trade essential goods and services enabled increased efficiency and productivity, inspiring evolving growth.
Financial System
A financial system is a mechanism that facilitates the exchange of funds between participants in the financial markets. These participants can include borrowers, lenders, and financial investors.
The financial system is a network of complex and closely knit services, markets, and institutions that aim to provide effective and efficient communication between investors and borrowers.
Banks, non-banking institutions, and international financial institutions all form a part of a financial system. Along with them, financial markets, money market mutual funds, and other financial assets and liabilities also form the same.
Fiscal and monetary policy
The government regulates a country's economy by enforcing fiscal and monetary policies that influence its citizens' socio-economic behavior and stimulate economic growth, all with the intent to achieve prosperity.
Central banks generally target to keep inflation at a rate of 2%, which is considered stable. The United States supports this as its target. However, the Federal Reserve, the central bank of the US, introduces monetary policy if the economy is growing exponentially or undesirably contracting.
The primary measure against inflation is the adjustment of interest rates that determine the cost of debt. Cheap debt is accompanied by low interest rates, which encourage consumers and businesses to borrow and spend, stimulating growth.
Expensive debt, portrayed by high interest rates, encourages consumers and businesses to reduce their debt and expenditures, leading to economic contraction.
Government fiscal policies can also play a role in controlling inflation by increasing the level of tax imposed on nationals, restricting income, and, subsequently, spending.
However, this is not advised as it directly impacts hard-earned incomes and employment gratification, often causing a lack of faith in the government.
Government entities spend tax revenue primarily on the welfare of their citizens, providing medical support to the vulnerable, funding the military for national security, and developing infrastructure projects for societal well-being.
Financial institutions are necessary for the financial system to prevail. It consists of three fundamentals:
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Credit
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Investment
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Insurance
Credit and investment enable stationary money to be directed into projects that can create new economic opportunities while, in return, gaining some revenue for the lender or investor if successful. However, it is not guaranteed and comes at the risk of losing the allocated funds.
On the other hand, insurance prepares individuals for contingencies that may arise, impacting the financial stability of a household or business, providing financial security, and limiting potential risks.
Real Economy Example
For example, suppose a car manufacturer produced 100 cars weekly, creating enough supply for 100 consumers weekly.
The car's retail price should cover all the expenses used to produce the vehicle, including materials, components, labor, etc., plus an additional percentage as profit.
The total expense of making the final product amounts to the car's intrinsic value. In contrast, the extrinsic value adds profit, which is determined initially by the manufacturer and then fluctuates based on consumer demand.
If 100% of cars are sold each week, with more requests than the output can deliver, there is high demand. This can increase the price based on how much consumers are willing to pay.
The price increases until consumer demand is at equilibrium with the weekly output. Consumers competitively outbid each other, lowering demand as consumers become less willing to purchase at the inflated price.
Progressing into the future, the car manufacturer has reinvested its profits to improve production. As a result, an additional output of 100 cars is available to consumers, doubling the weekly supply/output.
An increase in supply could reduce the car's retail price by closing the gap between low supply and high demand. This will ultimately lower the cost.
A significant increase in output overpowering demand can cause the retail price to decline drastically. Inventory may accumulate as no one is willing to pay the previous retail price.
Input expenses become more costly than actual sales revenue, forcibly lowering the price to be more competitive to spur demand.
Productivity can be measured using a company's net sales relative to employee labor hours.
Labor growth and salaries are company expenses; therefore, net sales would decline if the output remained the same while these other factors increased, illustrating a reduction in productivity.
For a company's productivity to increase, output has to grow faster than input.
Prior supply chains producing components necessary to build the car and the raw materials crafted to make those components must simultaneously maintain constant productivity levels for the car manufacturer to sustain its expected output level.
Growth is measured through the gross domestic product (GDP), the market value of all goods and services produced within an economy over time.
GDP can be divided by the size of a country's population to calculate the GDP per capita. This esse
Foreign exchange
An economy's performance and exchange rate with other currencies are considered independent. However, they can influence each other.
A disclaimer for these following few paragraphs, a currency can't singularly "appreciate" or "become stronger." These terms only apply when comparing two separate nations' monetary values.
Countries with a stronger currency can exchange it for a greater quantity of other coins. For example, at the time of writing, £1 is equivalent to $1.22. Therefore, for every unit of British currency exchanged, you receive an additional 0.22 of US currency.
The cost of importing UK goods to the US is made more expensive while promoting exports from the US to the UK as it is cheaper.
Typically, this promotes economic growth, as the export market thrives, bringing in capital from foreign trade and investment. This also boosts employment, increasing demand for cheaper goods and services.
The competitive nature of currencies balances the flow of trade, distributing capital between economies and stimulating growth and development.
The value of a currency appreciates when interest rates are high because it becomes more difficult to borrow the respective currency.
The value of a currency can depreciate when inflation rises too high, as the purchasing power weakens, meaning goods and services become less affordable.
A domestic industry in a developed country may be outcompeted by developing countries with cheaper products, making importing more appealing to businesses.
Domestic businesses would be unable to compete with a developing country since the value of their currencies may vary substantially, providing cheaper labor and production. In addition, the developing country may harbor relevant natural resources, giving them a supply-side advantage.
During a crisis, an exporting country will prioritize itself, ensuring domestic needs are met before the rest of the world. A global supply shortage of a specific product, especially in demand, can result in cost-push inflation for importing countries.
It may even be used as a monopoly weapon by the exporting country for a political agenda.
Governments impose tariffs as an additional tax on exports. This protects domestic industries by increasing the cost of cheaper foreign alternatives.
Real economy vs. Financial economy
Productivity represents the real economy and its ability to supply goods and services to demanding consumers. At the same time, the money supply represents the financial economy and its ability to provide capital for consumption and economic growth.
| Aspect | Real Economy | Financial Economy |
|---|---|---|
| Focus | Primary focus on the production and consumption of goods and services. | Primary focus on trading in financial assets such as stocks and bonds. |
| Types Of Goods | Deals with physical goods and services. | Financial instruments are primarily dealt with in the financial economy. |
| Participants | The main participants include business owners, consumers, and governments. | Here, the main participants are banks, financial institutions, and investors. |
| Measurement | Primary indicators of the real economy are GDP, employment rates, and industrial outputs. | Here, the main indicators are stock market indices, bond yields, and interest rates. |
| Societal Impact | Instrumental in providing goods and services for consumption, and employment opportunities. | The financial economy attracts investments and encourages lending, and economic stability. |
| Risk | Risks are related to economic cycles and demand fluctuations. | Risks are subjected to market volatility and speculations. |
| Regulations | The economy can be regulated by laws related to labor, production, and the environment. | Regulations in the financial economy could be related to financial regulations and securities laws. |
| Growth | Growth in the real economy is driven by innovation, productivity, and demand. | Growth here is influenced by different monetary policies, antitrust laws, and investor sentiments. |
| Longevity | Longevity is directly impacted by technological advancements. | Longevity is directly related to trends and market confidence, |
Businesses increase productivity to accommodate the high demand for their goods and services and may seek to accumulate debt or equity to finance their expansion.
The increased productivity leads to higher employment, lowering the unemployment rate and enabling most of the population to remain productive. In addition, this creates new cash flows, as employee wages further dilute the money supply.
Deflation and Consumer Behavior
During deflation, the money supply is too little compared to demand. This means that the currency slowly becomes more and more valuable, decreasing prices. While this may seem idyllic, it isn't.
In anticipation of further deflation, consumers will save money, decreasing demand for goods and services. This decrease in demand causes a price decline, creating a vicious cycle.
Businesses experience less consumer activity which would be reflected in profits. As a result, investors would see less income, and companies would reduce their expenditures to make debt repayments as a dollar of debt becomes more expensive when the purchasing power of a dollar rises. These increased debt repayments may result in employees being laid off.
A reduction in household and business income would burden debtors who must service liability payments, resulting in the possibility of default.
Productive assets are income-generating assets that provide a future cash flow. When consumers excessively direct credit to buy unproductive assets, it suppresses their potential future income.
When unproductive assets exceed productive assets, the productivity of an economy downgrades.
Therefore, unproductive assets cannot generate income contributing less to making debt repayments for their initial consumption.
Essential goods and services, such as food, shelter, clothes, and medicine, will always be in demand. Therefore, supply should always be in equilibrium.
However, demand for non-essential goods and services will fluctuate, as it is discretionary consumer spending. The demand for these products increases when the money supply increases and interest rates are low.
New credit can create a false narrative of increased wealth that may lead to overconsumption. This is because when the supply of money rises, consumers fail to acknowledge that the purchasing power of money decreases through inflation.
The knock-on effect for essential products would be substantial, as their prices will increase in unison and pressure the poorer population in the short run until wages are increased.
An example of current circumstances would be the pandemic. Monetary stimulus and policies, mainly quantitative easing, have flooded the economy with new money to help financially constrained households and stimulate growth through credit.
Supply constraints and lower productivity were experienced during the pandemic. However, the money supply increased, which induced spending and growth as interest rates remained low.
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