The real economy refers to all real or non-financial elements of an economy. An economy can be solely described using just real variables. A barter economy is an example of an economy with no financial elements. All goods and services are purely represented in real terms. A barter economy does not require the presence of an underlying monetary system.
Real variables are variables that don’t require the presence of an underlying monetary system for their representation.
Output in an economy can always be represented in real terms. All of the following statements are valid and don’t require the presence of a monetary system.
Company A produces 10 chairs and 5 tables in a week.
Company B produces 100 notebooks in a day.
Company C borrows 10 machines from Company D.
Wages or incomes in an economy can always be represented in real terms. All of the following statements are valid and don’t require the presence of a monetary system.
Company A pays its workers 5 apples a day.
Company B pays its workers 10 oranges an hour.
Consumer A is paid 2 bananas an hour.
Although the variables mentioned above are usually represented using units of money, money is not necessary for their representation. A monetary system allows us to simplify the exchange of goods and services in the economy. All goods and services are represented in units of money by dividing the real variable by the price of the real variable in monetary terms.
Example of Output
The value of output in an economy can be obtained by multiplying real output with the aggregate price of output. Consider the following statements:
The price of the chairs is $10, and the price of the tables is $20. Therefore, Company A produces $100 worth of chairs and $100 worth of tables in a week.
The price of the notebooks is $5. Therefore, Company B produces $500 worth of notebooks in a day.
The price of the machines is $100. Therefore, Company C borrowed $1,000 worth of machines from Company D.
Example of Wages
The nominal wage can be obtained by multiplying the real wage with the price level.
The price of one apple is $2. Therefore, Company A pays its workers $10 a day.
The price of one orange is $3. Therefore, Company B pays its workers $30 a week.
The price of one banana is $1. Therefore, Consumer A makes $2 an hour.
Banks and Financial Institutions
The growth of banks and other financial institutions has promoted economic growth and development across the world. Through banks, prospective businesses are able to borrow money that they need for initial set-up and growth.
In addition, banks have permitted modern economies to achieve greater degrees of specialization than the economies of the past. However, the growth of the financial economy has increased the potential for a purely financial crisis, leading to a decline in real variables such as output and employment.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: