Real economy
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The real economy concerns the
production Production may refer to: Economics and business * Production (economics) * Production, the act of manufacturing goods * Production, in the outline of industrial organization, the act of making products (goods and services) * Production as a stati ...
, purchase and flow of
goods In economics, goods are items that satisfy human wants and provide utility, for example, to a consumer making a purchase of a satisfying product. A common distinction is made between goods which are transferable, and services, which are not tran ...
and
services Service may refer to: Activities * Administrative service, a required part of the workload of university faculty * Civil service, the body of employees of a government * Community service, volunteer service for the benefit of a community or a p ...
(like
oil An oil is any nonpolar chemical substance that is composed primarily of hydrocarbons and is hydrophobic (does not mix with water) & lipophilic (mixes with other oils). Oils are usually flammable and surface active. Most oils are unsaturated ...
,
bread Bread is a staple food prepared from a dough of flour (usually wheat) and water, usually by baking. Throughout recorded history and around the world, it has been an important part of many cultures' diet. It is one of the oldest human-made f ...
and
labour Labour or labor may refer to: * Childbirth, the delivery of a baby * Labour (human activity), or work ** Manual labour, physical work ** Wage labour, a socioeconomic relationship between a worker and an employer ** Organized labour and the labour ...
) within an
economy An economy is an area of the production, distribution and trade, as well as consumption of goods and services. In general, it is defined as a social domain that emphasize the practices, discourses, and material expressions associated with the ...
. It is contrasted with the financial economy, which concerns the aspects of the economy that deal purely in transactions of
money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
and other
financial asset A financial asset is a non-physical asset whose value is derived from a contractual claim, such as bank deposits, bonds, and participations in companies' share capital. Financial assets are usually more liquid than other tangible assets, such as ...
s, which represent ownership or claims to ownership of real sector goods and services. In the real economy, spending is considered to be "real" as money is used to effect non-
notional ::''See Notional amount or Notional profit for economic terms '' Notional (born February 1, 2004 in California) is an American Thoroughbred racehorse. He was sired by In Excess and out of the mare Truly Blessed. His damsire, French Deputy, is ...
transactions, for example wages paid to employees to enact labour, bills paid for provision of fuel, or food purchased for consumption. The transaction includes the deliverance of something other than money or a financial asset. In this way, the real economy is focused on the activities that allow human beings to directly satisfy their needs and desires, apart from any speculative considerations. Economists became increasingly interested in the real economy (and its interaction with the financial economy) in the late 20th century as a result of increased global
financialization Financialization (or financialisation in British English) is a term sometimes used to describe the development of financial capitalism during the period from 1980 to present, in which debt-to-equity ratios increased and financial services acco ...
, described by Krippner as "a pattern of accumulation in which profits accrue primarily through financial channels rather than through trade and commodity production". The real sector is sensitive to the effect
liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity, the ease with which an asset can be sold * Accounting liquidity, the ability to meet cash obligations when due * Liqui ...
has on asset prices, for example if the market is saturated and
asset prices In finance, valuation is the process of determining the present value (PV) of an asset. In a business context, it is often the hypothetical price that a third party would pay for a given asset. Valuations can be done on assets (for example, inve ...
collapse. In the real sector this uncertainty can mean a slowdown in
aggregate demand In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is ...
(and in the monetary sector, an increase in the demand for money).


Schools of thought

In the neoclassical
school A school is an educational institution designed to provide learning spaces and learning environments for the teaching of students under the direction of teachers. Most countries have systems of formal education, which is sometimes compuls ...
of economics, the
classical dichotomy In macroeconomics, the classical dichotomy is the idea, attributed to classical and pre-Keynesian economics, that real and nominal variables can be analyzed separately. To be precise, an economy exhibits the classical dichotomy if real variables s ...
dictates that real and nominal values in the economy can be analysed distinctly. Thus, the real sector
value Value or values may refer to: Ethics and social * Value (ethics) wherein said concept may be construed as treating actions themselves as abstract objects, associating value to them ** Values (Western philosophy) expands the notion of value beyo ...
is determined by an actor's tastes and
preferences In psychology, economics and philosophy, preference is a technical term usually used in relation to choosing between alternatives. For example, someone prefers A over B if they would rather choose A than B. Preferences are central to decision theo ...
and the
cost of production Manufacturing cost is the sum of costs of all resources consumed in the process of making a product. The manufacturing cost is classified into three categories: direct materials cost, direct labor cost and manufacturing overhead. It is a factor i ...
, while the monetary sector only plays the part of influencing the
price level The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set. ...
, so in this simplified example the role of the
supply Supply may refer to: *The amount of a resource that is available **Supply (economics), the amount of a product which is available to customers **Materiel, the goods and equipment for a military unit to fulfill its mission *Supply, as in confidenc ...
and
demand In economics, demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given time. The relationship between price and quantity demand is also called the demand curve. Demand for a specific item ...
is generally limited to the
quantity theory of money In monetary economics, the quantity theory of money (often abbreviated QTM) is one of the directions of Western economic thought that emerged in the 16th-17th centuries. The QTM states that the general price level of goods and services is directly ...
).
Keynesian Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output and ...
theory rejects the classical dichotomy. Keynesians and
monetarists Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on nationa ...
reject it on the basis that prices are
sticky Sticky may refer to: People *Sticky (musician), alias of UK garage producer Richard Forbes * Sticky Fingaz or Sticky (born 1973), nickname of the US rapper and actor Kirk Jones Adhesion *Adhesion Adhesion is the tendency of dissimilar ...
– prices fail to adjust in the
short run In economics, the long-run is a theoretical concept in which all markets are in equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long-run contrasts with the short-run, in which there are some constraints an ...
, so that an increase in the money supply raises
aggregate demand In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is ...
and thus alters real macroeconomic variables.
Post-Keynesians Post-Keynesian economics is a school of economic thought with its origins in ''The General Theory'' of John Maynard Keynes, with subsequent development influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor, Sidney We ...
reject the classic dichotomy as well, for different reasons, emphasizing the role of banks in creating money, as in
monetary circuit theory Monetary circuit theory is a heterodox theory of monetary economics, particularly money creation, often associated with the post-Keynesian school. It holds that money is created endogenously by the banking sector, rather than exogenously by cent ...
.
Dichotomous market theory In macroeconomics, the classical dichotomy is the idea, attributed to classical and pre-Keynesian economics, that real and nominal variables can be analyzed separately. To be precise, an economy exhibits the classical dichotomy if real variables ...
proposes that real sector outcomes are independent of the monetary sector, related also to the idea of money neutrality.


Real property

Higher interest rates in the 1980s and 1990s reduced cash flows and decreased asset prices in several
OECD The Organisation for Economic Co-operation and Development (OECD; french: Organisation de coopération et de développement économiques, ''OCDE'') is an intergovernmental organisation with 38 member countries, founded in 1961 to stimulate e ...
countries especially as declining prices in
real estate Real estate is property consisting of land and the buildings on it, along with its natural resources such as crops, minerals or water; immovable property of this nature; an interest vested in this (also) an item of real property, (more general ...
and loan losses reduced equity in the banking sector lending decreased. As real estate values declined sharply in the Northeastern United States lending also decreased.


Real variables

Since the real economy refers to all real or non financial elements of an economy, it can be modeled by using only real variables, which don't need a monetary system to be represented. In this way, real variables are: * Wages: don't need to be expressed in monetary term, they can be expressed in real terms in any real unit ** Ex: 5 oranges for an hour of work (this is related to the concept of
purchasing power parity Purchasing power parity (PPP) is the measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries' currency, currencies. PPP is effectively the ratio of the price of ...
, which can be expressed in the Big Mac Index) * Output: can be expressed in terms of real unit ** Ex: a furniture company produces 20 tables and 40 chairs per day


Financial vs. real economy

According to the
classical dichotomy In macroeconomics, the classical dichotomy is the idea, attributed to classical and pre-Keynesian economics, that real and nominal variables can be analyzed separately. To be precise, an economy exhibits the classical dichotomy if real variables s ...
, the nominal and real economy could be analyzed separately. Mainstream economists often see financial markets as a means of equilibrating savings and investments, intertemporally allocated towards their best usage anchored by fundamentals within the economy. Banks thus act as an intermediary between savings and investments. Financial markets according to the
efficient-market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted bas ...
are deemed to be efficient based on all available information. The market interest rate is determined by the supply and demand for
loanable funds In economics, the loanable funds doctrine is a theory of the market interest rate. According to this approach, the interest rate is determined by the demand for and supply of loanable funds. The term ''loanable funds'' includes all forms of credit, ...
. There is some disagreement as to whether the financial sector and asset markets impact the real economy. Economist Mathias Binswanger demonstrated that since the 1980s, the results of the stock market do not seem to lead to increases in real economic activity, in contrast to the results found in Fama (1990), who found that increases in the stock market appear to lead to increases in the real economy. Binswanger attributes this difference based on the possibility of speculative bubbles for the economy during the 1980s and 1990s. Through analyzing seven countries, economist Kateřina Krchnivá found that an increase in the stock market predicts an increase in the real economy with the lag of one quarter, without any feedback relationship existing the other way around. Irving Fischer developed the theory of
debt deflation Debt deflation is a theory that recessions and depressions are due to the overall level of debt rising in real value because of deflation, causing people to default on their consumer loans and mortgages. Bank assets fall because of the defaults an ...
during the Great Depression to explain the linkages between the financial sector and the real economy. In his model, recessions and depressions are caused by an overall rise in the real debt level thanks to deflation. As a result, debt liquidation occurs followed by distress selling and a contraction of deposit currency. This leads to a further decrease in the price level and a wave of business bankruptcies, creating a drop in output, trade and employment. Pessimism and loss of confidence occur, leading to further hoarding and slower circulation of currency causing complicated disturbances in the interest rate. Fischer's remedy for when this sequence of events occur is to reflate prices back to its initial level, preventing that "vicious spiral" of debt deflation. Alternatively,
John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...
proposed the idea of
liquidity preference __NOTOC__ In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book ''The General Theory of Employment, Interest and Money'' (1936) to expl ...
as a means to explain how changes in investors' liquidity based on their unstable preferences in financial markets could lead to changes in real variables like output and employment. Thus, under conditions of fundamental uncertainty, liquidity becomes highly attractive to investors.
Keynesian economics Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output an ...
is concerned with ways of shaping investors' liquidity preference through monetary and fiscal policy channels in order to achieve Full Employment. The monetary authority can encourage more private investment through a reduction in the interest rate, while fiscal policy, a positive trade balance and housing credit expansions can also lead to further growth in the real economy.Bibow, J. (2011)
Financial markets
Levy Economics Institute of Bard College, Working Paper No. 660.


References

;Sources 1. Brender, A., Pisani, F. and Gagna, E. (2015)
Money, Finance, and the Real Economy: What Has Gone Wrong?
Centre for European Policy Studies, Brussels.
2. Christensen, Alex (2015)
"Where do financial markets end and the 'real economy' begin?
Globalriskinsights.com.


External links


Real Economy
at Corporate Finance Institute {{Authority control Subfields of economics Economics catchphrases