The IDMF (Integrating Dynamic Money-Flow)
Conceptual Framework and its Policy Implications

  1. The IDMF (Integrating Dynamic Money Flow) Conceptual Framework
    1. Money definition and money growth
    2. "Primary" Credit and the National Credit Balance
    3. The Integrated Money-Flow Macro Equation
  2. Implications for Macroeconomic Policy
    1. Monetary Policy
    2. Fiscal Policy
    3. International Monetary Fund
  3. Notes
Traditional macroeconomic "science" is admittedly in such shameful disarray that it often gives conflicting and inappropriate analysis and policy advice. Although not so generally realized, this disarray is itself due largely to the conceptually handicapped and functionally unintegrated condition of our present macroeconomic accounting systems.

The National Income and Product Accounts (NIPA) are unable to deal with money and credit, and thus leave a crucial financial gap between financial saving and the credit-financing of GDP spending. The Flow of Funds Accounts (FOFA) have no effective equivalent of the NIPA's "value added" concept for netting out double-counting intermediate credit flows, and thus are unable to fill the NIPA/s saving/investment gap with functionally appropriate data [1]. They also have no way of empirically tracing the key relationship between money growth and economic growth. Traditional Keynesian theory is based largely on the NIPA accounts, and neither Keynesian nor Friedmanite-monetarist theory has a precise and consistent definition of money.

I. The Integrating Dynamic Money-Flow
(IDMF) Conceptual Framework.
What has long been needed is a conceptual framework which can "complete the Keynesian Revolution" by making possible effective functional integration of the FOFA and NIPA. The IDMF framework being developed at the Institute For Economic Analysis attempts to do this.[2]

But pending full development of an integrated accounting system, even a basic understanding of money-flow conceptual and functional relationships facilitates a more effective approach to many macroeconomic problems -- not only for Japan, but also for other East Asian countries, Russia, Europe and even the U.S. itself. Unfortunately this understanding requires some effort -- not because the concepts themselves are difficult (as Keynes said of his own earlier conceptual revolution), but because of the way most of us have traditionally been trained to think about these things.

The basic money-flow questions. A key to understanding the money-flow approach is to ask of every transaction three questions: Where does the money come from? Where does the money go? and "What does the transaction do -- in, or to, the economy?
A. The Definition and Function of Money

A key aspect of the IDMF conceptual framework is that it makes possible a clear and precise separation of money and credit. These basic economic factors tend to be confused in traditional economic analysis and policy because of the credit concept of money and money growth that goes back to the medieval goldsmiths who invented "fractional reserve" checkable deposits.
Non-Credit Money. For effective functional analysis (and functional integration of economic accounts), money stock must be viewed conceptually not as a form of credit, but as a non-credit, pseudo-commodity ("physical") inventory stock of the means of payment -- the checkable deposits and currency that people actually pay bills and buy things with. [3] Thus, while no longer perfect either conceptually or statistically, what is now called M1 is the best available empirical measure of money. [4]
The Money Demand Ratio (MDR). At any given time, the stock of money inventory, like the stock of physical inventories, tends to have some "normal" structural/functional ratio to the corresponding flow -- in this case, best measured by total economic output, GDP. Thus, this M1/GDP stock/flow ratio is most appropriately thought of as the Money Demand Ratio. [5]

The Key "Multiplier" Relationship Between Money Growth and Economic Growth. In a growing economy, "New Money" created by the banking system plays a dual role:

  1. New Money SUPPLIES the additional Money STOCK to meet the economy's growing DEMAND for money-inventory to service the growing FLOW of GDP spending. The amount of M1 stock needed to service the policy-desired rate (level) of GDP spending is equal to the current trend value of the MDR multiplied by the corresponding flow of GDP spending.
  2. New Money is the chief financer of GDP growth -- by providing additional ("exogenous"-- not out of previous income) purchasing power for those who initially borrow the new money from money-creating (checkable-deposit) banks. Moreover, as that initial new money is re-spent again and again in its circulation around the economy, the initial spending is multiplied many fold. This Money Multiplier effect is limited only because, as the economy grows, new money becomes successively "locked into" the MDR-required level of individual money inventories. [6]
To the extent that the MDR remains constant, the precise amount of this multiplier is equal to the MDR reciprocal. [7] Thus, the present U.S. MDR of about 14% has a multiplier of about 7 -- i.e., each dollar of new money finances about 7 dollars of additional GDP. However, any change in the trend value of the MDR growth rate tends to have an equal and opposite effect on the GDP growth rate -- and on the amount of money stock needed to service the policy-desired rate of GDP growth.
The Money-Growth Formula -- relating money and GDP growth rates (gr):

GDP gr   =   M1 gr   -   MDR gr [8]
B. "Primary" Credit and the National Credit Balance

The concept of Primary Credit fills the NIPA "financial gap" between saving and investment by netting out FOFA intermediate ("pass-through") credit flows -- much as the "value added" concept nets out NIPA intermediate income and product flows. This makes it possible to empirically trace the way Primary Financial Saving flows through the Credit Market into the Primary Borrowing which finances each type of GDP spending.

The National Credit Balance -- i.e., the balance between the total supply and demand for Primary Credit -- largely determines the level of real interest rates. In the present global economy, this balance is obviously significantly affected by international money flows. And until individual countries' Flow of Funds Accounts adopt the IDMF Primary Credit conceptual framework, it will be impossible to tell how much of the international flow represents real Primary Credit, and how much is confusing and destabilizing double-counting intermediate credit.
C. The Integrated Money-Flow Macro Equation
Together, the Primary Credit and Non-Credit Money concepts make possible the following modification of the traditional Keynesian macroeconomic equation. [9] [10]

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

II. Implications for Macroeconomic Policy

The IDMF conceptual framework provides an empirical basis for systematically coordinating fiscal and monetary policy as complementary rather than alternative policy tools. [11]
A. Monetary Policy.

The primary objective of monetary policy should be to manage the GDP growth rate more precisly, by an explicit and open Monetary Policy Formula (rather than indirectly and secretly through interest rates), to achieve a stable "soft landing" (asymptotic) approach towards the economy's maximum non-inflationary operating rate and lowest unemployment rate. Control of interest rates should be delegated to fiscal policy; control of non-monetary sources of inflation to other policy tools.
Monetary Policy Formula: [12]

Real M1 growth rate =
Policy-target real GDP growth rate [13]
Current trend value of the MDR growth rate
B. Fiscal Policy

In the IDMF conceptual and policy framework, the federal deficit is considered as one component -- along with consumer, business and rest-of-world borrowing -- of total borrowing in the National Credit Balance. But the federal deficit (or surplus) differs fundamentally from other sectors' borrowing in that the federal government can (if it wishes) control the stabilization component of its borrowing (see below) by controlling the growth -- and unemployment rate -- of the whole economy -- as the U.S. Federal Reserve and the Clinton Administration so effectively demonstrated during 1992-99.

Thus, the main objective of fiscal policy -- as distinguished from budget policy -- should be to maintain a stable National Credit Balance (between the economy's total supply and demand for credit), at appropriate low real interest rates. It can best do this by pro-actively adjusting the amount of the total budget deficit (positive or negative) so as to compensate for destabilizing changes in private consumer and business borrowing.
To do this most effectively -- with optimum public understanding and political support -- the deficit must be separated, explicitly and clearly, into its two functional economic components, the Policy Budget Deficit, and the Stabilization Deficit: [14]

C. Implication for International Monetary Fund policy.

The IMF needs to adopt the IDMF conceptual framework. It highlights the apparent failure of the International Monetary Fund to distinguish between the two functionally-very-different deficit components, and the counterproductive nature of their demands for budget "austerity" and total deficit reduction in severely depressed economies.

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Note 1
Their intra-sector sources/uses discrepancies are so large and so variable that their key data lack the needed credibility.
(back to ref 1)

Note 2
This is the reason for the word "integrating" in the IDMF title. The word "dynamic" is included because this framework makes possible effective empirical analysis of the dynamic "multiplier" relationship between money growth and economic growth.

For more on this framework, with illustrative money-flow diagrams, see the related other items on this site -- particluarly the Visual Analysis page.
(back to ref 2)

Note 3
This conceptual treatment is as if all money were paper bills printed by the Treasury and borrowed by the banks for re-lending (or kept by the Treasury, as "seigniorage," for reducing the national debt), and as if all banks had to maintain 100% reserves against all checkable deposits.

It is useful to remember that checks are not themselves money. A check -- like an electronic cash card transaction -- is merely an order to one's bank to transfer some of one's existing checkable deposit money to someone else. But a credit card is basically different. In a money-flow conceptual framework, a credit card purchase is a more complex, credit, transaction in which the card-holder borrows money from the credit-card bank, which sends the borrowed money directly to the seller, rather than to the card-holder borrower.
(back to ref 3)

Note 4
The Federal Reserve's M2 "money and credit aggregate,"which is now probably the most widely used definition of money, world-wide, could well be called a monetary fraud. In a dynamic money-flow perspective (as distinguished from the static double-entry-accounting perspective used by banks and the FOFA), three-fourths of M2 is not money at all.

Except for those few components that have been unwisely permitted limited 3rd party check writing privileges since 1980, all but a quarter of M2 is merely a collection of credit assets -- savings deposits, certificates of deposit, money-market accounts, etc. Funds in these accounts must be withdrawn as currency or transferred into a checkable account -- i.e. converted into money -- before they can be spent.

Even more important analytically, an increase in these credit assets does not have the key "monetary multiplier" effect because they are not, like checkable deposits, created exogenously ("out of thin air"), but rather come out of savers' previous incomes in the macroeconomic circular flow of money.

Thus, basing monetary analysis or policy on the behavior of M2 can be seriously misleading -- as the Fed has found recently. And to the extent that the financial markets and general public accept that functionally-false definition of money it can sometimes prevent the Fed from taking really appropriate monetary policy action.
(back to ref 4)

Note 5
This ratio has the same value whether the numerator and denominator are both expressed in nominal values or in "real" values deflated by the same price index (preferably the GDP deflator).
(back to ref 5)

Note 6
This limiting process is very similar to the way the checkable-deposit reserve multiplier is limited by the way new reserve money becomes successively absorbed into the additional legally-required reserve balances.
(back to ref 6)

Note 7
This reciprocal concept, traditionally called "velocity," is best thought of as the money-inventory "turnover" rate -- a flow/stock ratio also commonly used in business.
(back to ref 7)

Note 8
As the formula indicates, a decline in the "normal and necessary" MDR -- as during the long decline from 42% in 1948 to 16% in 1978 -- releases money previously "locked into" normal money inventories, and thus has the same effect on GDP growth as an increase in New Money. For instance, during 1955-65 the almost constant 3% trend decline of the MDR made possible a 3% trend increase in real GDP with practically no increase in real M1. (This is much the way a computer-induced reduction in physical inventory/sales ratios releases more goods for sale without a corresponding increase in current production.) Conversely, an increase in the MDR, as caused by a reduction in interest rates, or by payment of interest on checkable deposits, increases the required supply of New Money. It is in this kind of real-world operational perspective that the superiority of the MDR concept over the traditional "velocity" is most evident.
(back to ref 8)

Note 9
The empirically quantifiable Non-Credit-Money and Primary Credit concepts in this equation make it possible "empiricize" Keynesian analysis by conceptual and analytical integration of financial and non-financial data without resort to the non-empirical, market-oriented Keynesian concepts of "liquidity preference" and esoteric IS/LM diagrams.
(back to ref 9)

Note 10
Unlike the Keynesian/NIPA equation, this one is equally applicable on a micro basis, providing a macro-oriented framework for the accounts of individual economic units. If individual businesses were required to report their balance sheets on this basis, it would provide a much better basis for calculating the integrated national economic accounts. Of course, the individual component equations are true only in the macro accounts:

Income = Spending
Primary Borrowing = Primary Financial Saving
New Money = Increase in M1 Money Inventory
(back to ref 10)
Note 11
This policy-coordinating model would be particularly useful in the "Euroland" effort to prepare for the Euro monetary union, both technically and in generating more universal political support.
(back to ref 11)

Note 12
This formula assumes that the monetary authority can actually control the supply of M1 with a fair degree of precision. This precision can of course be greatly increased by a high reserve requirement (100% optimal), and also by more precise separation between money and credit -- particularly by prohibiting both payment of interest on M1 deposits and 3rd-party check writing on interest-paying credit assets.

The "real" M1 growth rate is adjusted, of course, by the GDP deflator, to reconcile the two sides of the equation. This version of the formula recognizes implicitly that maintaining structural economic balance requires that money inventory stocks, like physical inventory stocks, need to maintain their normal ratio to GDP flows as the economy grows, whether they are expressed in nominal or real values.

A nominal-value version of this equation would use the nominal M1 growth rate on the left side, and add the GDP inflation rate on the right side.
(back to ref 12)

Note 13
The Policy Target Growth rate should be the Potential GDP growth rate plus a non-inflationary asymptotic "soft landing" recovery component. This recovery component should be based on a formula which reduces the GDP growth rate systematically as the economy's "operating rate" (actual GDP as % of potential) increases and unemployment rate declines, based on the country's historical relationships and policy tools.

This "automatic" reduction of money growth during recovery tends to prevent the economy from running into inflationary supply shortages before it can rebuild its productive capacity to full-employment levels -- thus tending to prevent purely monetary inflation.

If there are non-monetary causes of inflation -- such as OPEC or other monopolistic-market-power price or wage increases, or tax increases, or inappropriate COLA formulas -- these should be countered by other anti-inflation tools, not by reduced economic growth and higher unemployment.
(back to ref 13)

Note 14
Clearly separating these components makes it easier to distinguish between deficits which represent budgetary mismanagement, which has the economic effect of unnecessarily raising interest rates and taking capital away from productive private investment, and deficits which represent economic mismanagement, which hurts both government and private budgets.
(back to ref 14)

Note 15
A key reason why this dishonest fiscal sleight-of-hand has been allowed to continue is the traditional economists' focus on the NIPA accounting perspective, which, because it is unable to deal with credit flows, nets borrowing against positive financial saving, thus showing the "net influence" of federal financing on the economy.
(back to ref 15)

Note 16
Adjusting federal spending for counter-cyclical purposes is conceptually inappropriate, administratively clumsy, politically difficult, and usually poorly timed.
(back to ref 16)

Written: July 8, 1998
Last revised: April 23, 1999
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