Real Economy

Constitutes all the active components of an economy, excluding the financial and monetary elements

Author: Christopher Haynes
Christopher Haynes
Christopher Haynes
Asset Management | Investment Banking

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds asset management firm with $20 billion under management, and as an investment banking analyst in SunTrust Robinson Humphrey's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Reviewed By: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Last Updated:October 12, 2023

What is the Real Economy?

The real economy constitutes all the active components of an economy, excluding the financial and monetary elements used as an intermediary of trade.

The productivity of an economy is the ratio between the output and input volumes. It is a measure of 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).ntially computes the average production value of each citizen in an economy.

Key Takeaways

  • The real economy involves the production of goods and services, driven by factors like supply, demand, and productivity.
  • The bartering system, where goods were directly exchanged, was replaced by physical money, easing trade complexities. Over time, currencies transitioned from commodity money (gold, silver) to fiat money, which relies on government stability.
  • Governments regulate economies through fiscal policies (taxation, spending) and monetary policies (interest rates, money supply).

Bartering system

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.

For instance, exchanging goods and services would have been more complex.

Suppose a baker and a plumber wanted to trade services since the baker needed his plumbing done and the plumber needed food to eat. The pair would agree on the exchange rate of bread for the plumbing service.

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.

Secondly, we may fairly negotiate the exchange rate of bread for the plumbing service. However, the plumber would likely end up with more bread than they knew what to do, suggesting the plumbing job was complex and, therefore, required a larger bread payment.  

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.

In the modern age, it would be impractical to barter. It can, however, 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.

For the car manufacturer example previously mentioned, you can see how complex and inefficient this process would be, from paying laborers to acquiring car components.

The introduction of a monetary and financial system advanced trade and evolved civilizations. However, some aspects of the financial system have dissociated from the role of trade and productivity, causing divergences and phases of instability.

People can specialize in producing specific goods and valuable services to cultivate a diverse and skilled economy through currency. 

The monetary and financial system

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.

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.

The next stage was "representative money," which pinned paper money to a quantity of gold, known as the gold standard. But, again, the limitations were apparent, as deflationary pressures emphasized when gold increased in value, reducing the dollar's value.

A restrictive supply of gold made it more difficult for the dollar to sustain value and remain competitive against other currencies. Ultimately, this is why we dropped the standard in favor of our current fiat currency system. 

The aggregates of money supply and consumer demand have provided an autonomous system.

However, the majority of the US money supply in circulation consists of credit, compared to fiat money which would account for a single percentage of the entire money supply. 

Fiat money is physical money that is printed and has a value backed by a government. The stability of the government and economy where the fiat currency is issued determines, in part, its importance and security.

As fiat currency holds no intrinsic value and is not associated with another commodity, it is subject to inflation and deflation.

Credit holds the same value as fiat currency but is effectively digits on a bank's balance sheet.

Purchasing with credit uses borrowed money from a bank and requires the borrower to make principal repayments at a future date, possibly with interest.

Once credit is given to the borrower, it becomes debt.

The bank can limitlessly increase the money supply within an economy by extending credit to consumers. The only variable they must manage is their risk, involving the assets and liabilities on their balance sheet.

If a bank's liabilities exceed its assets, they become insolvent, possibly leading to bankruptcy. 

All current/deposit accounts available to consumers are liabilities to the bank, as they are obligated to pay depositors an equivalent amount of fiat currency upon withdrawal request. Otherwise, they remain as digital figures on the bank's balance sheet.

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.

Tax revenue is spent by government entities, primarily for the welfare of its citizens, providing medical support to the vulnerable, funding military for national security, and developing infrastructure projects for societal wellbeing.

Financial institutions are necessary for the financial system to prevail. It consists of three fundamentals:

  • Credit

  • Investment

  • 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

Concerning the various points above about the natural and financial economy, both systems must function together, as displacements may result in economic instability. This has been experienced many times in the past.

In this instance, 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.

The money supply is constantly increasing through credit that banks issue. This is essentially a currency that had not existed in the system before the bank issued it as credit. 

When credit is readily available, consumers buy goods and services, releasing money to businesses and investors.

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. 

Productivity is increased by investing in research and development (R&D) for new productive assets, such as technology.

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.

The gross profit from company sales is used to settle expenses such as employee wages and debt obligations. The remainder is the net profit that is distributed to company shareholders. 

When the supply of money increases, as seen during government quantitative easing programs, interest rates decrease as money is more readily available.

During the pandemic, quantitative easing (QE), which increases the money supply, was introduced along with stimulus packages, drastically expanding the money supply. As a result, consumers and businesses can service debt quickly when interest rates are low, increasing spending.

The point of borrowing is to spend credited money in the present and pay back the debt later with future income.

Businesses perform well when consumer confidence is high. This entices investors to provide capital to gain returns from profiting companies. Consequently, riskier investments are adopted as they are capable of reaping greater returns.

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 reflect 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.

Researched and Authored by Rohan Hirani | Linkedin

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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