The paper economy, or financial economy, refers to the part of the economy that is made up of non-real or financial variables. All transactions and activities in the paper economy take place on paper, i.e., there is no exchange of real goods and services.
Consider the following example: Investor A buys $10,000 worth of bonds from Bank A. Investor A transfers $10,000 to Bank A and the bank transfers the bonds to the investor. No real goods are exchanged. Investor A simply receives a piece of paper from Bank A that says that a certain number of bonds are now in his name. Within the paper economy, all claims on assets are through documents.
Advantages and Disadvantages of a Paper Economy
Economists argue that the paper economy causes inflation in the economy through quasi-real transactions (no transfer of possession) and an unnecessarily large number of transactions for the same commodity. However, financial markets do provide some benefits. For one, they allow companies in need of funds to raise capital through a public offering.
Relevance of Legal Claims
The paper economy is based on the exchange of legal claims over assets. The exchange happens with the help of financial markets. The markets seek to bring together buyers of claims and sellers of claims. The price of the claim is determined by the market forces of supply and demand.
It is important to note that the market for claims on a good or service is different from the market for the good or service. The difference can be better understood through an example. Consider the market for chairs and the market for claims on chairs. The market for chairs is part of the real economy and involves the buying and selling of a real good: chairs. The market for claims on chairs is part of the paper economy and only involves the exchange of pieces of paper between the market participants.
In theory, each claim can be exchanged for a chair from the real economy, but in practice, the two markets function independently.
Transactions in the real economy involve the exchange of real goods and assets whereas transactions in the paper economy only involve the exchange of legal claims through the financial markets. The paper economy makes up a large portion of the entire global economy, as most economic activities in the world today are paper economy-based.
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: