IEA Indicators
Brief Description

How to Read The Economy Through IEA Charts

Part II. A Brief Description of IEA Indicators

(See first: "How to Read IEA Charts, Economic Fluctuations in Growth Perspective",
and, preferably, Part I of this series: "How the Economy Works")

IEA charts include two main types of indicators:

  1. Key measures of economic performance, and
  2. Key analytical ratios which show basic structural relationships.

The IEA Charts Handbook, which accompanied all subscriptions to IEA's Pocket Charts, described in considerable detail the indicators and the analytical framework on which they are based. This is a brief (and somewhat "oversimplified") introduction.

As each chart series is mentioned, its reference number (see How to Read IEA Charts) is noted in parentheses. You will probably find it helpful to refer to the charts as you read.

 
A. The Key Measures of Overall Economic Performance

These include measures of production and operating rates, employment and unemployment, prices and incomes. Except for the ORE (Operating Rate of the Economy) these are commonly used indicators which require little explanation here.

 
B. The Analytical Ratios

Money Supply
Inflationary Supply/Demand Relationships
Investment and Financing
The Federal Budget

These ratios show changes in the proportional -- or "structural" -- relationships among key aspects of the economy. Most are ratios to actual GNP (total national spending). Analytically, these are similar to the ratios used to analyze the operations and financial statements of business firms -- ratios which often use sales volume as the denominator.

The norms for most of these series are not mere mathematically-derived trends (regressions), but rather the estimated "balanced-growth" (stable full-employment) values for the present U.S. economy. They are comparable to the normal ratios for particular types of business that are used as standards of reference to evaluate the actual ratios of individual firms.

Thus, the shaded deviations from the norms show the degree and direction of the structural imbalances and distortions which are of basic analytical significance in determining why the economy is performing the way it is at any particular time. In many cases these deviations also have clear implications for future economic performance and for the economic policies which would be needed to correct the imbalances and improve performance.

 
Money Supply   (Panels 2 and 19, Charts 18.1-3)

The term "money supply" is often used to refer to two quite different things:

  1. the total stock of money inventory (i.e. currency and checking account balances), and
  2. the flow of new money to the economy (i.e. the net increase in the stock).

Chart 18.3 shows the total stock measured, like "real" GNP (18.6), in dollars of constant purchasing power. Chart 2.1 shows its growth rate.

The demand deposit growth rate (2.3) is shown separately because this is the only component of the money supply that is actually controlled by the Federal Reserve, and thus reflects more accurately the effects of a "tight money" policy. The amount of currency in circulation is determined entirely by the public's actual need for money to service its current rate of transactions.

As explained in How the Economy Works, Section B, the real money supply growth rate is probably the single most important factor determining the growth rate of the whole economy (GRE, 1.2).

How fast an effect on GNP? -- In the early years after World War II, when the money stock was very large in relation to GNP and interest rate s were low, changes in the real money supply growth rate tended to require almost a year to produce a corresponding effect on the real GNP growth rate. During the early 1960's, with relatively stable GNP growth and stable prices, and with both the money/GNP stock/flow ratio (see below) and interest rates close to what appear to have been their long-run historical norms, the lag was about half a year. During 1955-58 and 1969-73, periods of generally "tight money," very high interest rates and inflation, the lag was reduced to about one quarter. Since 1973, a change in the real money supply growth rate seems to produce an almost immediate corresponding effect on GNP.

(However, in attempting to use the money supply series for very short-run analysis or policy, it is important to note that a significant part of the large short-run fluctuations in these series is due to "technical" factors -- such as transfers between federal and private deposits, poor seasonal adjustments, and an apparent effort by the Fed to camouflage its current basic policy -- that have little functional significance. Both IEA and the Federal Reserve are now studying possible means of reducing at least the statistical vagaries.)
 
The monetary STOCK/FLOW RATIO: the structural "demand" for money  (Panel 19) -- If a bank requires a $300 minimum balance in checking accounts to avoid service charges, depositors will try to keep their balances above $300. Then, if the bank reduces its minimum to $200, depositors will, in effect, have an additional $100 to spend, or to lend (indirectly, by transferring the funds to a savings account) to someone else to spend. The net effect on total spending of this decline in the stock/flow ratio (cf. How the Economy Works, Section B) would be much the same as if the $100 had come from newly created money.

Thus, the income-generating effect of any particular increase in the money supply (2.1) is augmented by the "new money equivalent" of a decline in the stock/flow ratio (19.3a) -- an effect implicitly allowed for in the norm for chart 2.1. (IEA is working to develop a single measure of the "effective money supply" which will combine these two aspects in a functionally significant and conceptually valid manner, for inclusion in Panel 2.)

Panel 19 shows various monetary stock/flow ratios. Functionally, these are comparable to the stock/flow ratios for physical inventories (cf. explanation of Panel 9 below). However, while the normal stock/flow ratio for physical inventories (Asia) seems to have remained virtually constant for the past 30 years, the normal monetary stock/flow ratio has had a long-run declining trend, caused by such factors as rising interest rates (which induce businesses and households to keep only the essential minimum in their checking deposits, and to keep all "surplus" cash "invested" in savings deposits or other "earning assets"), computerized analysis of spending and income flows, and electronic fund transfers.

Evaluating the significance of short-run changes in the stock/flow ratio -- The stock of money inventory (18.3) like the stock physical inventories (Panel 9), plant and equipment, debt (Panel A-3) and credit assets (Panel A-4) -- tends to have less short-run flexibility than spending-and-income flows (18.7). Consequently, in sharp economic contractions like 1973-75, the money/GNP ratio tends to rise above its basic long-run trend even while the stock of money is declining.

Then, after the "tight-money" policy is reversed and both the money supply and the economy start to recover, the money/GNP ratio falls back towards its long-run trend. The resulting "depression blip" is essentially a statistical illusion with little functional significance.

Thus, for better perspective on the behavior of the money/GNP ratio, Panel 19 shows the ratio of the money stock to four different flow concepts --

In sharp economic contractions like 1974-75, the ratio to final sales tends to remain closer to the underlying trend than the ratio to GNP, because it eliminates the effect on GNP of the so-called "inventory cycle."

For historical analysis the ratio to Peak-Trend GNP, like the ratio to Capacity GNP, tends to reflect monetary policy ("tight money" vs. "easy money"), while not departing as far from the basic trend. But it is obviously less reliable in a current depression when the next recovery peak can only be anticipated).

Whither the trend and why? -- The primary purpose of the Federal Reserve should be to supply the economy with the amount of money inventory it needs. The Fed has actually paid most attention to interest rates (which reflect mainly the demand for credit), and has done very inadequate research on the underlying factors which affect the "demand for money" -- i.e., the amount of checking deposits and currency which businesses and households consider normal-and-necessary at any given time in relation to their current flow of spending and income.

By using several relatively independent analytical approaches, IEA has made what we believe to be a reliable estimate of the long-run trend of the stock/flow ratio (18.3a) for the 25 years from 1948:3 to 1973:3 -- a constant -3.2% decline from 1950:3 to 1966:2 and a -2% decline from 1966:2 to 1972:2. But we have as yet not found adequate explanation of why the trend was so stable for such long periods, or why it changed in 1966.

Presently available evidence indicates that the basic trend probably changed again after 1973. But, again, it is not yet fully clear why it changed, whether it is yet on a stable new track, and, if so, for how long. These are critically important questions on which Federal Reserve should do far more intensive research -and share the results with the public.

The dotted-line -3.5% projection of 19.3a connects the pre-1973 trend with the actual ratio at 1976:2. This is also approximately the -3% trend which the St. Louis Federal Reserve Bank considers the best estimate of the real trend. The "barred" projection beyond 1976:2 is the range implied by Dr. Burns' August 1976 projections of GNP and the money supply.

Money supply growth-rate norm  (2.1a) -- Because of the uncertainty regarding the basic trend of the money/ GNP ratio, the growth rate norm is also shown in two variants. The lower one reflects a continuation of the -2% pre-1973 trend, the upper one reflects the -3.5% dotted-line projection.

Note that the 1% difference between these two variants, while quite large in relation to the range of uncertainty regarding the actual trend of the money/GNP ratio, is very small indeed compared to the past "rollercoaster" fluctuations of the money supply, and much less, even, than Chairman Burns' 4.5% to 7% "target" range for the money supply growth rate -- a range, incidentally which is as wide as the range of 45 to 70 mph in a car, a rather broad range for so basic a variable.

The "non-money M's'' -- Household savings deposits and other "near money" credit assets which are erroneously and confusingly included in the Fed's M2 to M7 "money and credit aggregates" are shown in Panel 16.

 
Inflationary Supply/Demand Relationships   (Panels 4 and R-4A)

These charts show some of the key indicators of "bottleneck" supply shortages and other imbalances in nonfinancial supply/demand relationships which tend to increase the market power of sellers by making buyers more willing to pay higher prices to obtain needed supplies. (See discussion of inflation in How the Economy Works, Section E)

The norm for each series is at the level which seems to coincide most closely with a significant increase in the rate of inflation (charts 5.1-3).

The materials production charts (4.1-2) show both capacity (4.1) and production (4.2) (instead of merely the operating rate), in order to show how capacity is itself reduced by prolonged depression. Panel R-14A shows another perspective on the adequacy of capacity.

 
Investment and Financing   (Panel 7 and How the Economy Works)

Panel 7 (Housing) -- Housing is placed after Panel 6 because of the key role interest rates play in the rate of housing construction. This Panel shows housing construction in terms of dwelling units (rather than expenditure, as in 8.10) in order to relate housing construction to household formation. It shows, for instance, that the 1971-73 housing "boom" -- which contributed so much to the inflation of housing costs and the inflationary excess demand for credit during that period (11.6, 11.3) -- was more than merely a response to lower interest rates (6.1) and more plentiful mortgage credit (16.7). It also apparently reflected a demographic "wave" of household formations just a generation (23 years) after a similar "boom" during 1947-50 (H7.4) -- which suggests that housing starts may not again approach the 1971-73 rates for another generation unless they are specially stimulated by lower interest rates, public subsidies, lower construction costs, or some other structural improvement in the housing industry.

Note also the way in which the rental housing vacancy rate (4.10) -- a significant factor in rent inflation -- was affected by the 1966-67 and 1974-76 "tight-money" housing depressions and the abnormally low margin between housing starts and household formation during 1968-71.

Investment spending  (Panel 8) and Primary Financing  (Panels 11 and 12) -- These are shown on adjoining pages because of the close functional relationships between them, as described in How the Economy Works, Section C. Panel 10 shows the relationships between corporate investment and financing in a single sources-and-uses of funds presentation.

Most of the charts in Panel 8 are familiar series from the national income accounts. However, household motor vehicles (8.9) have been added to the traditional national income measure of Gross Private Domestic Investment because:

  1. they perform services which compete with airplanes, buses, trains, taxis, trucks, and other business-owned transportation equipment,
  2. they tend to be financed with credit and provide a similar "mortgageable asset" basis for debt and borrowing,
  3. they put a roughly similar demand on the inflation-prone basic raw materials and skilled labor, and
  4. their volume of production (and related borrowing) tends to have similarly large fluctuations.

The large fluctuations of investment spending tend directly to exacerbate both depressions (1.1) and inflations (5.5). In addition, the sub-normal rate of investment during depressions tends to reduce the nation's plant and equipment capacity (4.1, R-4.1) below what is needed at full employment, and thus to exacerbate the problem of inflationary bottleneck shortages (Panel 4) during recovery towards full employment.

Charts 8.7a and 8.8a show the amount of investment exclusive of pollution abatement equipment. The pollution abatement component usually adds little to productive capacity, but the total amount of investment (8.7, 8.8) must be financed in one way or another, thus increasing the amount of financing needed from profits (10.6) and/or borrowing (12.1).

Panel 9: Nonfarm business inventories -- Inventories are often called the "pipelines" of production and distribution. Contrary to a common misconception, only about 30% are goods "on the shelves" ready for sale to final consumers The rest are raw materials, components in process of production, goods in transit or in warehouses, etc.

Stock/Flow Ratios -- The stock of inventories tends to be closely related to the amount of goods "flowing" through this "pipeline." The normal inventory/sales ratio (9.2a) is about 22% of business final sales -- or about 18% of GNP. In order to maintain this normal stock/flow ratio as total output increases, nearly one-fifth of the total increase in GNP tends to become "locked into" the rising inventory stocks, and thus is not effectively available for sale to non-business final purchasers. It must be purchased and financed by business itself (Panel 10).

The stock of physical inventories, like the stock of capital equipment, money, debt or credit assets, tends to have less short-run flexibility than spending and income flows. Consequently, in sharp economic contractions like 1973-75, the ratio of inventory stocks to actual final sales (9.2) tends to rise far above its norm, even while the stock itself is declining.

Thus, for better perspective on the behavior of the actual stocks, Panel 9 also shows the ratio of the stocks to Capacity GNP final sales (9.5) and to peak-trend final sales (9.3 -- cf. also 18.7a)

Panel 9 shows that the stock/flow ratios are usually higher than normal during periods of rising prices (5.2, 5.3), which provides a speculative motive for holding larger than minimum inventories -- especially when the rising prices also reflect actual shortages (4.6, 4.7), thus adding a "supply insurance" motive.

"Inventory cycles" -- As noted in How the Economy Works, Section C, inventory investment tends to be particularly subject to the "acceleration principle," reflecting in magnified degree any large changes in the GRE. Thus, inventory "liquidation" and rebuilding is a major factor in accelerating the rate of recession -- and subsequent rate of recovery -- whenever the GRE is allowed to fall much below zero. In Panel 18 this can be seen clearly in the relationship of Actual GNP (18.7) and final sales, adjusted (18.6).

The ratio of stocks to the Capacity GNP rate of final sales (9.5) indicates the size of the "pipeline gap" (9.4) which must be filled in the process of recovery towards Capacity GNP. This process of inventory rebuilding causes an inflationary distortion of normal structural relationships, and is one of the reasons why economic fluctuations give an inherently inflationary bias to the economy.

 
The Federal Budget  (Panels 12-14)

Panel 14B is the National Income Accounts perspective on federal spending and receipts.

The High-Employment Budget (Panel 14A) estimates the spending and income which would result from a stable 4% unemployment rate (the same basis as "Potential" GNP, 18.4a). The H.E. Budget has a dual analytical value:

  1. it indicates the economic impact of fiscal policy decisions better than the actual budget, which is influenced so greatly by changes in the ORE (1.1), and
  2. it provides a consistent administrative and legislative basis for analyzing changes in fiscal policy over a series of years, and for effective budgetary planning and control, independent of the effect of changing economic conditions.

In Panel 12 the federal surplus or deficit is presented in the form of federal borrowing, for consistency with private borrowing. This panel shows both the high-employment component (12.5) and the total (actual) borrowing (12.3), with the difference between them labeled "Automatic Stabilizer Component" (12.4). This component, which measures the effect on the budget of changes in the ORE (1.1), is shown separately in Panel 13, where it is labeled "depression deficit."

Although traditionally thought of in its relation to private spending and income flows, the Automatic Stabilizer Component is functionally much more significant in its relation to private credit flows. Note the "mirror images" of federal borrowing (12.3) and business borrowing (12.1). This is because depressions have a roughly equal but opposite effect on them, with business inventory financing going down, while government tax receipts go down and unemployment benefits up.

Panels 12 and 13, which present state and local government borrowing in the same way as federal, show how severely the current depression has affected their finances.

Panel R-14A is a "pile-up" presenting all federal expenditures except social insurance benefits and military. Panel R-14B presents social insurance benefits and contributions together (for comparability with private pension funds, which will be included in a later issue of IEA CHARTS). Note how the present social security "crisis" is largely due to the depression.

Financial Saving Components  (Panel 16B) -- These, together with the increase in money supply (2.2), constitute the sources of the funds which finance total primary borrowing (11.3). Notable in this panel are the huge shifts between savings deposits -- particularly in commercial banks (16.6) -- and market securities (16.4) during 1966-67, 1969-71, and 1973-76, caused by Federal Reserve "tight-money" policies and resulting sharp fluctuations of market interest rates (6.2, 6.4).

Corporate Stock  (Panel 16A) -- In a short-run perspective, stock prices tend to reflect rates of return on competitive investments. Thus, when a "tight-money" policy (2.1) increases interest rates (Panel 6) (and causes recession (1.1), with resulting lower profits (10.6) and dividends), stock prices (R-16A.1) tend to decline.

However, "in the long run" the total value of outstanding stock (R-16A.2) presumably tends to reflect the value of the corporate assets, which in turn tend to be related to the value of what they produce. The total value of corporate stock seems to have reached some sort of "equilibrium" ratio to GNP by the early 1960's, and the earnings/price ratio (R-16A.3) had declined from a post-World War II peak of about 16 in 1949-50 to about 5.5% in 1959, but returned to that rate during each subsequent (partial) recovery. Thus, if the ratio of total stock value to Capacity GNP can be expected to regain the apparent "norm" of the 1960's (about 90% of Capacity GNP) general economic recovery to somewhere near full employment offers the potential for a considerable increase in stock prices.


Written: 1976
Posted: August 4, 2009
Last revised: January 1, 2010
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