Real economy

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The real economy concerns the production, purchase and flow of goods and services (like oil, bread and labour) within an economy. It is contrasted with the financial economy, which concerns the aspects of the economy that deal purely in transactions of money and other financial assets, which represent ownership or claims to ownership of real sector goods and services. [1]

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In the real economy, spending is considered to be "real" as money is used to effect non-notional 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, described by Krippner as "a pattern of accumulation in which profits accrue primarily through financial channels rather than through trade and commodity production". [2]

The real sector is sensitive to the effect liquidity has on asset prices like, for example, if the market is saturated and asset prices collapse. In the real sector this uncertainty can mean a slowdown in aggregate demand (and in the monetary sector, an increase in the demand for money). [3]

Schools of thought

In the neoclassical school of economics, the classical dichotomy dictates that real and nominal values in the economy can be analysed distinctly. Thus, the real sector value is determined by an actor's tastes and preferences and the cost of production, while the monetary sector only plays the part of influencing the price level, so in this simplified example the role of the supply and demand is generally limited to the quantity theory of money). [4] [3]

Keynesian theory rejects the classical dichotomy. Keynesians and monetarists reject it on the basis that prices are sticky – prices fail to adjust in the short run, so that an increase in the money supply raises aggregate demand and thus alters real macroeconomic variables. Post-Keynesians reject the classic dichotomy as well, for different reasons, emphasizing the role of banks in creating money, as in monetary circuit theory.

Dichotomous market theory proposes that real sector outcomes are independent of the monetary sector, related also to the idea of money neutrality. [3]

Real property

Higher interest rates in the 1980s and 1990s reduced cash flows and decreased asset prices in several OECD countries especially as declining prices in real estate 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. [5]

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:

Financial vs. real economy

According to the classical dichotomy, 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 are deemed to be efficient based on all available information. The market interest rate is determined by the supply and demand for loanable funds.

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. [6] 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. [7]

Irving Fischer developed the theory of debt deflation 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. [8]

Alternatively, John Maynard Keynes proposed the idea of liquidity preference 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 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. [9]

Related Research Articles

<span class="mw-page-title-main">Keynesian economics</span> Group of macroeconomic theories

Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. Instead, it is influenced by a host of factors – sometimes behaving erratically – affecting production, employment, and inflation.

<span class="mw-page-title-main">Macroeconomics</span> Study of an economy as a whole

Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy's growth and stability. This includes regional, national, and global economies.

<span class="mw-page-title-main">Inflation</span> Devaluation of currency over a period of time

In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. The opposite of inflation is deflation, a decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index. As prices faced by households do not all increase at the same rate, the consumer price index (CPI) is often used for this purpose. The employment cost index is also used for wages in the United States.

<span class="mw-page-title-main">Deflation</span> Decrease in the general price level of goods and services

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<span class="mw-page-title-main">IS–LM model</span> Macroeconomic model relating interest rates and asset market

IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that shows the relationship between interest rates and assets market. The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when the price level is fixed in the short-run; second, the IS–LM model shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.

This aims to be a complete article list of economics topics:

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In economics and political science, fiscal policy is the use of government revenue collection and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variables developed in reaction to the Great Depression of the 1930s, when the previous laissez-faire approach to economic management became unworkable. Fiscal policy is based on the theories of the British economist John Maynard Keynes, whose Keynesian economics theorised that government changes in the levels of taxation and government spending influence aggregate demand and the level of economic activity. Fiscal and monetary policy are the key strategies used by a country's government and central bank to advance its economic objectives. The combination of these policies enables these authorities to target inflation and to increase employment. Additionally, it is designed to try to keep GDP growth at 2%–3% and the unemployment rate near the natural unemployment rate of 4%–5%. This implies that fiscal policy is used to stabilise the economy over the course of the business cycle.

An economic bubble is a period when current asset prices greatly exceed their intrinsic valuation, being the valuation that the underlying long-term fundamentals justify. Bubbles can be caused by overly optimistic projections about the scale and sustainability of growth, and/or by the belief that intrinsic valuation is no longer relevant when making an investment. They have appeared in most asset classes, including equities, commodities, real estate, and even esoteric assets. Bubbles usually form as a result of either excess liquidity in markets, and/or changed investor psychology. Large multi-asset bubbles, are attributed to central banking liquidity.

<i>The General Theory of Employment, Interest and Money</i> 1936 book by John Maynard Keynes

The General Theory of Employment, Interest and Money is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision making.

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The causes of the Great Depression in the early 20th century in the United States have been extensively discussed by economists and remain a matter of active debate. They are part of the larger debate about economic crises and recessions. The specific economic events that took place during the Great Depression are well established.

<span class="mw-page-title-main">Liquidity trap</span> Situation described in Keynesian economics

A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest."

Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption. Neutrality of money is an important idea in classical economics and is related to the classical dichotomy. It implies that the central bank does not affect the real economy by creating money. Instead, any increase in the supply of money would be offset by a proportional rise in prices and wages. This assumption underlies some mainstream macroeconomic models. Others like monetarism view money as being neutral only in the long run.

<span class="mw-page-title-main">Liquidity preference</span> Interest seen as a reward for parting with liquidity

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 explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless refrained from consuming all his current income. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity. According to Keynes, money is the most liquid asset. Liquidity is an attribute to an asset. The more quickly an asset is converted into money the more liquid it is said to be.

<span class="mw-page-title-main">Modern Monetary Theory</span> Macroeconomic theory

Modern Monetary Theory or Modern Money Theory (MMT) is a heterodox macroeconomic theory that describes currency as a public monopoly and unemployment as evidence that a currency monopolist is overly restricting the supply of the financial assets needed to pay taxes and satisfy savings desires. MMT is opposed to the mainstream understanding of macroeconomic theory and has been criticized heavily by many mainstream economists.

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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 and because the value of their collateral falls, leading to a surge in bank insolvencies, a reduction in lending and by extension, a reduction in spending.

<span class="mw-page-title-main">History of macroeconomic thought</span> Aspect of history

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

<span class="mw-page-title-main">Endogenous money</span>

Endogenous money is an economy’s supply of money that is determined endogenously—that is, as a result of the interactions of other economic variables, rather than exogenously (autonomously) by an external authority such as a central bank.

<i>The Return of Depression Economics and the Crisis of 2008</i> 2008 edition of 1999 book by Paul Krugman

The Return of Depression Economics and the Crisis of 2008 is a non-fiction book by American economist and Nobel Prize winner Paul Krugman, written in response to growing socio-political discourse on the return of economic conditions similar to The Great Depression. The book was first published in 1999 and later updated in 2008 following his Nobel Prize of Economics. The Return of Depression Economics uses Keynesian analysis of past economics crisis, drawing parallels between the 2008 financial crisis and the Great Depression. Krugman challenges orthodox economic notions of restricted government spending, deregulation of markets and the efficient market hypothesis. Krugman offers policy recommendations for the prevention of future financial crises and suggests that policymakers "relearn the lessons our grandfathers were taught by the Great Depression" and prop up spending and enable broader access to credit.

References

  1. ↑ Batko, M. (2013). The Real Economy and the Finance Economy. Munich: BookRix
  2. ↑ Krippner, G. (2005). “The financialization of the American economy,” Socio-Economic Review, 3, 173-208
  3. 1 2 3 Reintroducing Macroeconomics. M. E. Sharpe. 2007. pp. 134–42. ISBN   978-0765614506 . Retrieved 8 August 2019.
  4. ↑ Rousseas, Stephen (2005). Post Keynesian Monetary Economics. Routledge. p. 19. ISBN   1315486156 . Retrieved 8 August 2019.
  5. ↑ Holmstrom, Bengt (1997). "Financial Intermediation, Loanable Funds, and the Real Sector". The Quarterly Journal of Economics. 112 (3): 663–691. JSTOR   2951252.
  6. ↑ Binswanger, M. (2000). Stock market booms and real economic activity: Is this time different? International Review of Economics & Finance. Volume 9, Issue 4, October 2000, Pages 387-415 doi.org/10.1016/S1059-0560(99)00056-8
  7. ↑ Krchnivá, Kateřina. 2016. Do Stock Markets Have Any Impact on Real Economic Activity? Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, 64(1): 283–290 doi.org/10.11118/actaun201664010283
  8. ↑ Fisher, Irving. 1933a. The Debt-Deflation Theory of Great Depressions. Econometrica, 1(4): 337-357. Also published in Revue de l’Institut International de Statistique 1934(1): 48-65. Reprinted in Fisher, 1997(10), 337-343.
  9. ↑ Bibow, J. (2011). Financial markets. Levy Economics Institute of Bard College, Working Paper No. 660.
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.

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