The Circular Flow of Money
Chart 3

IEA's Integrating Dynamic Money Flow (IDMF) conceptual framework makes it possible to analyze empirically the key dynamic relationship between money growth and economic growth by making a clearcut distinction between Money and Credit, using two devices:

This diagram adds two conceptual abstractions to the money-flow analysis: Although newly-created Money can flow directly to governments as seigniorage, in this diagram it flows to the Credit Market because, in our credit-money economy, most New Money is actually created by individual banks in the process of making loans.

The Reserve Multiplier.  The banks' money-creating power is limited by the reserves they are required to hold against checkable deposits. When the Fed wants to increase the supply of New Money, it buys Treasury securities with Fed-created Reserve Money, which comes back to the Fed as bank reserve deposits. The amount of New Money created this way is equal to the reciprocal of the required reserve ratio -- now about 10%. Thus, each dollar of new reserves enables the banks to create ten dollars of New Money.

The Money Multiplier and the Money Demand Ratio (MDR).  The New Money created by banks is not "used up" when it's first spent; it continues to circulate around the economy, re-spent over and over. Each time it's re-spent it adds something to the economy's total spending/output (the GDP). But this multiplier effect, like the reserve mutliplier, is limited. As the flow of GDP (and corresponding national income) increases, so does the stock of Money Inventory needed to service it -- just as a super-market's stock of grocery inventory needs to increase as its flow of sales increases. Thus, all the New Money becomes progressively locked into people's increasing money-inventory stocks -- just as additional reserve money becomes progressively locked into the banks' required reserves.

The Money Demand Ratio (MDR)  is the ratio of money stock to GDP flow. The value of the money multiplier is the reciprocal of the MDR -- just as the value of the reserve multiplier is the reciprocal of the reserve ratio. With the present MDR of about 14%, the money multiplier is about 7 -- each dollar of new money finances seven dollars more GDP.

The Basic Money-Growth/GDP-Growth Equation.  Since GDP growth is usually measured in growth-rates rather than dollars, it is useful to express the money-growth/GDP growth relationship the same way (gr= growth rate):

GDP gr = M1 gr - MDR gr

Note that an increase in MDR growth rate has the same effect as a decline in M1 growth rate.
As a monetary policy guide, the formula could be stated another way:

M1 gr = policy-desired GDP gr + MDR gr

That is, the Fed can manage the economic growth rate by very precisely monitoring the current MDR trend growth rate, and managing M1 growth accordingly. Managing economic growth by this transparent and easily understandable formula would be more precise than its present focus on interest rates, and also make Fed-watching much simpler and less disturbing to the capital markets.

The Fed's Money-Management leverage problem.  If you like mind-benders, how about this: if the reserve multiplier is 10, and the money multiplier is seven, then the combined reserve/GDP multiplier is 70 -- each dollar of new reserves creates $70 more GDP. Talk about leverage! Actually, it's even greater and less precise than that, because the required reserve ratio is now so low that a large proportion of banks need that amount of vault cash anyway, and are effectively out of Fed control.

In any case, that leverage is too great for the Fed to directly target reserves as its means of managing the GDP growth rate. That is undoubtedly a key reason why the Fed resorts to the conceptually less precise method of ostensibly targeting short-term interest rates. When the Fed sells Treasury securities to reduce bank reserves and money creation, this also reduces the total supply of credit and increases interest rates. But the relationship between interest rates and money creation is not precise -- particularly since an increase in interest rates also tends to reduce the MDR by inducing the movement cash into higher-interest assets and the development of ways to function on smaller cash balances. This has the same effect as an increase in the money supply. As a result, the Fed is now forced to resort to an ad hoc, trial-and-error approach to money and GDP management.

But whether the Fed ostensibly uses interest rates or M1 as its control lever, the obvious solution for the excessive reserve/GDP leverage is to increase the required reserve ratio -- optimally to 100%. Unfortunately, bank resistance has made that reform, long recommended by leading economists, politically difficult.

The IDMF Macro Equation

This modification of the traditional Keynesian/NIPA macro equation expresses the money-flow relationships in the above full IDMF circular-flow diagram, and provides the basis for functional integration of the NIP and FOF national economic accounts. Unlike the Keynesian/NIPA macro equation, this one is also applicable on a micro basis, providing a macro-oriented framework for the accounts of individual economic units.

Income + Primary Borrowing + New Money
= Spending + Primary Financial Saving + Increase in Money Inventory

To the Circular Flow diagram introduction
To the previous step, which excludes Monetary Authority and Money Inventories.
To the initial step, which excludes Monetary Authority, Money Inventories, Credit Market and Primary Credit flows.

Last revised: September 23, 2000
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