Real Side of the Economy
Real side of the economy depends on how efficiently labor and capital are used to produce the goods and services. This efficiency is the measure of the level of technology used by the economy in producing the goods and services. The real economy is also affected by the changes in size and quality of capital stock through investment and labor force available for production.
While analyzing the real side of the economy our primary focus is on the real interest rates, real wages and
real output of the economy.
Nominal Side of the Economy
The nominal side of the economy deals with the total demand of the final goods and services produced in an economy. The demand of the goods and services is driven by the money at hand. The primary demand creator for the goods and services are households who spend their disposable incomes at hand. This side of the economy plays important role determining the price level for the goods and services.
In analyzing the nominal side of the economy our focus is on the nominal factor prices such as wages and price levels which adjust to ensure market equilibrium and are determined by the supply factors and demand for factors (determined by the price level and the technology)
Effects of Financial Crisis on Real and Nominal Sides of the Economy
Financial Crisis
A financial crisis is a crisis that originates in the financial markets of the economy. These financial markets are stock market, commodity market and other money markets. The first negative effect of the financial crisis is bore by the players in financial markets i.e. commercial banks, other financial intermediaries such as depository institutions, housing finance companies, lease financiers and other non-banking financing institutions (Dornbush, Fischer, Startz, 2007).
Link of Financial Markets with Real and Nominal side of Economy
In a free economy these financial intermediaries play an important role in for the demand side and the supply side of the output of the economy. For demand side they provide loans to individuals for personal consumptions (such as car loans, housing loans etc.) and for the supply side they provide loans to corporate houses which invest the money in buying capital and building new projects which helps in further boosting up the output of the economy.
This fine connection of the financial intermediaries makes it inevitable that any financial crisis affects both real economy and the nominal side of the economy. In a financial crisis the liquidity is dried up and banks and other financial intermediaries run for their available liquidity options to survive themselves in the market (sometime with the help of government) consequently resulting in to lesser money lent for personal consumption and new projects. The lesser money lent to the households results in lesser demands for goods and services in the economy. The lesser the demand, lesser the production of factors, eventually, leading to the lower profits (often losses) of the industries. This affects the job market too, in which unemployment level rises suddenly due to jobs cuts by the industries to minimize their costs as an effort to minimize their overall losses.
This shows that industries bear the brunt of the financial from two sides first they have lesser access to the finances due to dried liquidity in the financial markets and second, the demand of their factors also comes down. In these situations government steps up and takes measures to increase the aggregate demand by available fiscal policies. These policy measures can be either tax cuts or increased government spending in infrastructural projects. Usually a developing economy has more scope for government spending through spending in infrastructural investment however, for a developed economy like U.S. the tax cut and other excise rate cuts are the only feasible options available. The government also tries to use monetary policies to uplift the liquidity position by interest cuts.
Current Financial Crisis
The current financial crisis is an example of how financial crisis can lead up to the crisis real side of the economy. This crisis started in the financial markets of the U.S. which led to the bankruptcy of leading financial institution and then eventually spreading its aftereffects in to the real economy and affecting automobile sector, textiles and other industries severely. This crisis has resulted in the waning consumer and business confidence. The global unemployment in the formal sector has risen to 6.5 in 2009, which is a total of 210 million people out of work, and 77 million in workers in developing countries to be pushed into poverty.
The governments from across the world have taken steps to prevent this crisis into becoming a long lasting labor market crisis. Many economic recovery packages are targeted at the real economy to stimulate demand, such as cutting taxes and boosting government spending, targeting infrastructure development, spending on education and health etc.