The Money Growth Formula

The basic relationship

In a TREND sense, real economic growth is the result of the effect of the current demand for money (money demand ratio, or MDR, measurable as M1/GDP) on the change in spendable money balances (M1).

gr(GDP)  =  gr(M1)  -  gr(MDR)

This is not a tautology

One might assume this at first glance to be a tautology, since "obviously"

GDP = M1 / (M1/GDP)

However, this would only be true if GDP and M1 were inherently independent of each other, and the MDR was simply a description of their relationship. In fact, the situation is quite different.

The MDR describes how the economy is managing the money it uses in generating GDP spending. Although the only convenient measure we have for it is M1/GDP, it is, in fact, an independent characteristic of the economy -- the degree to which interest rates and other factors induce people to economize (or not) on cash balances. To the extent that people manage to economize on cash balances and still maintain a given level of economic (GDP) activity -- i.e., a decreasing MDR -- less money is necessary to support a given level of GDP.)

The policy formula

To determine the amount of growth in nominal (current-dollar) M1 necessary to achieve a certain degree of nominal economic growth, the above relationship must be adjusted for inflation, the best overall economic measure of which appears to be the National Income measure of the deflator for final sales. This results in the following prescriptive relationship between money and economic growth:

+ change in


target policy target current trend current trend
gr( M1nominal ) = gr( GDPreal ) + gr( MDR ) + gr( FS-defl )

The components of a policy target for economic growth

In IEA's frame of reference, the ideal economic environment is one in which planning by business and households is facilitated by the predictability offered by stable full-employment without inflation. Getting to that environment involves economic growth with two components:

  1. the underlying trend of Potential (high-employment) GDP, and
  2. an asymptotic ("soft-landing") Recovery component, related to the unemployment rate gap -- the excess of the current unemployment rate over the "high-employment unemployment rate"
gr( GDP ) = gr( P-GDPtrend ) + Recovery

Under this formula, initially rapid economic growth in a period of high employment slows gradually as growth reduces the unemployment rate gap (and thus its component in the formula). Eventually, growth slows to that of Potential GDP, characterized by normal increases in

  1. productivity, and
  2. labor force

Posted: May 24, 1998
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